Elanco Animal Health Inc (ELAN)

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Introduction

Management’s discussion and analysis of financial condition and results of operations (MD&A) is intended to assist the reader in understanding and assessing significant changes and trends related to our results of operation and financial position. This discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying footnotes in Item 8 of Part II of this Form 10-K. Certain statements in this Item 7 of Part II of this Form 10-K constitute forward-looking statements. Various risks and uncertainties, including those discussed in "Forward-Looking Statements and Risk Factor Summary" and Item 1A. “Risk Factors,” may cause our actual results, financial position and cash flows to differ materially from these forward-looking statements.

Business Overview

Elanco is a global leader in animal health, dedicated to innovating and delivering products and services to prevent and treat disease in farm animals and pets. Our diverse, durable product portfolio is sold in more than 90 countries and serves animals across many species, primarily: dogs and cats (collectively, pet health) and cattle, poultry, swine, sheep and, prior to the divestiture of our aqua business in July 2024 (see below), aqua (collectively, farm animal). With a heritage dating back to 1954, we consistently innovate to improve the health of animals and to benefit our customers while fostering an inclusive, cause-driven culture for our employees. We operate our business in a single segment, directed at advancing the well-being of animals, people and the planet, enabling us to realize our vision of Food and Companionship Enriching Life.

Our diverse product portfolio of approximately 200 brands helps make us a trusted partner to pet owners, veterinarians and farm animal producers. Our products are generally sold worldwide to third-party distributors and independent retailers and directly to farm animal producers and veterinarians. In recent years, we have expanded our omnichannel presence in both the veterinary clinic and in retail markets, including e-commerce.

Product Development and Regulatory Update

A key element of our targeted value creation strategy is to drive revenue growth through portfolio development and product innovation. We continue to pursue the development of new chemical and biological molecules, as well as additional registrations and indications for current products. Our future growth and success depend on both our pipeline of new products, including new products we develop internally, develop with partners or that we obtain through licenses or acquisitions, and the life cycle management of our existing products. We believe we are an industry leader in animal health R&D, with a track record of successful product innovation, business development and commercialization. New product development and regulatory highlights during 2024 included the following:

Bovaer: In May 2024, the FDA completed its comprehensive, multi-year review of Bovaer (3-NOP), a first-in-class methane-reducing feed ingredient for use in lactating dairy cattle. Producers began feeding the product to cattle in the U.S. during the third quarter of 2024.

Zenrelia: We received final FDA approval for Zenrelia, a JAK inhibitor targeting control of pruritus and atopic dermatitis in dogs, in September 2024. We launched Zenrelia shortly after final approval, with the first sales occurring in late September. We have also received approval for Zenrelia in Brazil, Canada and Japan. Additional reviews are ongoing in other key markets, including Europe, U.K. and Australia.

Credelio Quattro: In October 2024, we received final approval from the FDA for Credelio Quattro, a monthly chewable tablet for dogs that protects against fleas, ticks, heartworms, roundworms, hookworms and three different species of tapeworms. Credelio Quattro was launched, with the first commercial sale occurring in January 2025.

Experior: In October 2024, we received multiple combination clearance approvals from the FDA for Experior to be used in combination with other farm animal products, allowing for broader use in heifers, which represent nearly 40% of the fed cattle population in the U.S.

Other Key Trends and Factors Affecting Our Results of Operations

Aqua Business Divestiture: On July 9, 2024, we closed the sale of our aqua business to a subsidiary of Merck Animal Health, for $1,294 million in cash. We utilized a vast majority of these proceeds to repay previously outstanding term loan debt, thereby reducing our leverage and expected future interest expense. Our aqua business included products across both warm-water and cold-water species and generated revenue of $81 million in 2024, through the divestiture date, and $175 million in 2023. Strategically, this divestiture has allowed us to prioritize our investments in larger markets with greater long-term earnings potential.

Assets sold included inventories, real property and equipment, including our manufacturing sites in Canada and Vietnam, and certain intellectual property, technology and other intangible assets, including marketed products.

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Along with these assets, approximately 280 commercial and manufacturing employees were transferred to Merck Animal Health as part of this divestiture. We recorded a pre-tax gain on divestiture of $640 million, while income tax expense associated with this gain was approximately $170 million, a majority of which is payable in 2025. See Note 4. Acquisitions, Divestitures and Other Arrangements to the consolidated financial statements for further information.

Acquisition and Integration Activity: In November 2024, we acquired a manufacturing facility in Speke, U.K., including its workforce and related assets such as inventory and property and equipment, from a former contract manufacturing supply partner, TriRx Speke Ltd (TriRx Speke), for $36 million.

In 2023, we acquired certain U.S. marketed products, pipeline products, inventory and an assembled workforce from NutriQuest, LLC (NutriQuest) and certain assets including inventory and distribution rights for certain marketed products from NutriQuest Nutricao Animal Ltda (NutriQuest Brazil). Additionally, we successfully completed the integration of the Bayer Animal Health business into our ERP system, including the build out of processes and systems to support our global organization. See Note 4. Acquisitions, Divestitures and Other Arrangements and Note 5. Asset Impairment, Restructuring and Other Special Charges to the consolidated financial statements for further information on these acquisition and integration activities.

Restructuring Activities: In February 2024, our Board of Directors authorized a restructuring plan (the restructuring plan) to improve operational efficiencies and better align our organizational structure with current business needs, top strategic priorities and key growth opportunities. Specifically, the restructuring plan was intended to reallocate resources by shifting international resources from farm animal to pet health as we plan for the global launches of certain potential blockbuster products. Further, the restructuring plan impacted how we operate in and sell into the Argentina market, among others, reducing our foreign currency exposure in those markets.

We incurred $44 million of charges associated with the restructuring plan in 2024, the majority relating to cash-based severance costs. The restructuring plan is expected to result in annualized net savings of $30 to $35 million. See Note 5. Asset Impairment, Restructuring and Other Special Charges to the consolidated financial statements for further information.

Results of Operations

The following discussion and analysis of the consolidated statements of operations should be read along with the consolidated financial statements and the notes thereto included in Item 8. Financial Statements and Supplementary Data. For results of operations discussions related to the years ended December 31, 2023 and 2022, refer to Item 7 of Part II in our Annual Report on Form 10-K for the year ended December 31, 2023, filed with the SEC on February 26, 2024. Our results of operations for the periods presented below may not be comparable with prior periods or with our results of operations in the future due to many factors, including but not limited to the factors identified in the "Product Development and Regulatory Update" and "Other Key Trends and Factors Affecting Our Results of Operations" discussions above.

Certain amounts and percentages may reflect rounding adjustments.

NM - Not meaningful

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Revenue

Our products are sold in more than 90 countries, and as a result, a significant portion of our revenue is recorded in currencies other than the U.S. dollar. Because of this, our revenue is influenced by changes in foreign currency exchange rates. For the years ended December 31, 2024 and 2023, approximately 53% and 51%, respectively, of our revenue was denominated in foreign currencies.

Further, increases or decreases in inventory levels in our distribution channels can positively or negatively impact our periodic revenue results, leading to variations in revenue. This can be a result of various factors, such as end customer demand, new customer contracts, heightened and generic competition, the need for certain inventory levels, our ability to renew distribution contracts with expected terms, our ability to implement commercial strategies, regulatory restrictions, unexpected customer behavior, proactive measures taken by us in response to shifting market dynamics, payment terms we extend, which are subject to internal policies, blackout shipping periods due to system downtime, implementations and integrations and procedures and environmental factors beyond our control.

Our revenue by product category for the years ended December 31, 2024 and 2023, was as follows:

Note: Numbers may not add due to rounding

(1)Represents revenue from arrangements in which we manufacture products on behalf of a third party and royalty revenue.

The effects of price, foreign currency exchange rates, volume changes and the impact of the divestiture of our aqua business on changes in revenue for the year ended December 31, 2024, as compared to the prior year, were as follows:

Pet health revenue increased $39 million, or 2%, driven by a 3% increase in pricing, partially offset by slightly lower volumes. Volume decreases were primarily due to competitive pressure on certain products in the U.S. veterinary channel and purchasing patterns of certain over-the-counter (OTC) products by U.S. retailers. These decreases were partially offset by revenue from new products and improved demand for retail parasiticide products in certain European markets, including Spain.

Farm animal revenue decreased $21 million, or 1%, driven by the divestiture of our aqua business in July 2024, which we estimate resulted in a decrease of $84 million in revenues year-over-year, and to a lesser degree the impact of foreign currency exchange rates. Partially offsetting these decreases were a 2% increase in pricing and higher volumes for our non-aqua products. Volume increases of non-aqua products were driven by strength in U.S. cattle, led by Experior and Rumensin, and strength in poultry sales globally, partially offset by weakness in global swine markets, volume declines associated with our previous strategic decisions to change how we operate in and sell into certain international markets, including Argentina, and the impact from the European recall of Kexxtone, which occurred during the second quarter of 2024.

Cost of Sales

Cost of sales increased $72 million in 2024 as compared to 2023, and cost of sales as a percentage of revenue increased from 44% to 45% year-over-year. These increases were due to a combination of inflation, planned reduced throughput at certain manufacturing sites and product mix associated with the divestiture of our aqua business, partially offset by increased pricing.

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Research and Development

R&D expenses increased $17 million, or 5%, in 2024 compared to 2023, primarily driven by higher employee-related expenses and timing of project costs.

Marketing, Selling and Administrative

Marketing, selling and administrative expenses increased $29 million, or 2%, in 2024 compared to 2023, primarily driven by higher advertising and employee-related expenses and investments supporting our global pet health business, partially offset by cost savings associated with the completion of our ERP system integration in the second quarter of 2023 and the restructuring plan that was authorized and initiated in the first quarter of 2024.

Amortization of Intangible Assets

Amortization of intangible assets decreased $21 million in 2024 compared to 2023. This decrease was primarily driven by changes in foreign currency exchange rates and the elimination of amortization related to our aqua business intangible assets, which met the criteria to be classified as held for sale on February 1, 2024, at which date amortization of these intangible assets ceased. See Note 4. Acquisitions, Divestitures and Other Arrangements to the consolidated financial statements for further information.

Asset Impairment, Restructuring and Other Special Charges

Amounts recorded to asset impairment, restructuring and other special charges during the year ended December 31, 2024, included a $53 million impairment charge related to the write-off of a pet health IPR&D asset, $44 million of costs associated with the restructuring plan discussed above, $18 million of acquisition and divestiture-related charges, primarily associated with our aqua business divestiture, and $15 million of asset impairments tied to the financial difficulties of our former contract manufacturing supply partner, TriRx, the largest of which was a $12 million impairment of a contract asset related to a favorable supply agreement.

Amounts recorded to asset impairment, restructuring and other special charges during the year ended December 31, 2023, primarily represented $93 million of costs associated with the implementation of new systems, programs and processes due to the integration of Bayer Animal Health and $32 million of asset impairment charges. For additional information regarding our asset impairment, restructuring and other special charges, see Note 5. Asset Impairment, Restructuring and Other Special Charges to the consolidated financial statements.

Goodwill Impairment

As previously disclosed, there was a sharp increase in long-term treasury rates during the third quarter of 2023, and as a result, we assessed our long-lived assets, including goodwill, for impairment. Due principally to an increased discount rate assumption, which was driven by the sharp increase in long-term treasury rates, our quantitative goodwill impairment test resulted in a $1,042 million pre-tax impairment charge. For additional information, see Note 11. Goodwill and Intangibles to the consolidated financial statements.

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Gain on divestiture

As discussed above, we recorded a pre-tax gain of $640 million on the divestiture of our aqua business during the third quarter of 2024. For additional information, see Note 4. Acquisitions, Divestitures and Other Arrangements to the consolidated financial statements.

Interest Expense, Net of Capitalized Interest

Interest expense, net of capitalized interest decreased $42 million in 2024 compared to 2023, primarily due to lower average outstanding debt balances given our debt repayment activity in the current year (see Note 8. Debt to the consolidated financial statements for further information), as well as increased interest income from our net investment hedges, which we record as contra-interest expense, net of capitalized interest (see Note 9. Financial Instruments to the consolidated financial statements for further information). These decreases were partially offset by a $12 million non-cash charge in 2024 related to the write-off of previously deferred financing costs, given our early debt repayments.

Other Expense, Net

Other expense, net for the year ended December 31, 2024, primarily consisted of foreign currency exchange losses and an $8 million write-down of the retained equity interest in our previously divested BiomEdit R&D platform (see Note 4. Acquisitions, Divestitures and Other Arrangements to the consolidated financial statements for further information). Other expense, net for the year ended December 31, 2023, primarily consisted of foreign currency exchange losses of $50 million and settlement provisions of $15 million related to the Seresto class action lawsuit and $12.5 million for a possible resolution or settlement with the SEC related to potential disclosure claims, which was ultimately settled in 2024 for $15 million, with the increase in the provision recorded within other expense, net in 2024 (see Note 16. Commitments and Contingencies to the consolidated financial statements for further information).

Foreign currency exchange losses were lower in 2024 in large part due to the restructuring plan actions in the current year, which impacted how we operate in and sell into the Argentina market, among others, reducing our foreign currency exposure in these markets.

Income Tax Expense

Income tax expense was $150 million in 2024 compared to $36 million in 2023. Income tax expense in 2024 included approximately $170 million related to income tax associated with the taxable gain on the divestiture of our aqua business. Our effective tax rate of 31% in 2024 differed from the statutory income tax rate primarily due to the income tax associated with the gain on the divestiture of our aqua business, jurisdictional earnings mix of income in higher tax jurisdictions and losses for which no tax benefit was recognized. These factors were partially offset by our ability to realize certain net operating loss carryforwards and other tax attributes, which had historically been offset by a valuation allowance, due to the gain on the sale of our aqua business, and the recognition of certain state tax credits.

The negative effective tax rate in 2023 differed from the statutory income tax rate primarily due to the recognition of the goodwill impairment charge recognized in 2023 that was non-deductible for income tax purposes in most of the impacted jurisdictions, as well as an increase in our valuation allowance, primarily attributable to the likelihood of not realizing the benefit of U.S. federal and state deferred tax assets due to pre-tax losses.

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Liquidity and Capital Resources

Our primary sources of liquidity are cash on hand, cash flows from operations and funds available under our credit facilities. As a significant portion of our business is conducted internationally, we hold a significant portion of cash outside the U.S. We monitor and adjust the amount of foreign cash based on projected cash flow requirements. Our ability to use foreign cash to fund cash flow requirements in the U.S. may be impacted by local regulations and, to a lesser extent, the income taxes associated with transferring cash to the U.S. We intend to indefinitely reinvest substantially all foreign earnings for continued use in our foreign operations. As our business evolves, we may change that strategy, particularly to the extent we identify tax efficient reinvestment alternatives for our foreign earnings or change our cash management strategy.

We believe our primary sources of liquidity are sufficient to fund our short-term and long-term existing and planned capital requirements, which include working capital obligations, funding existing marketed and pipeline products, capital expenditures, business development in our targeted areas, short-term and long-term debt obligations, including both principal and interest payments, as well as interest rate swaps, operating lease payments, purchase obligations and costs associated with mergers, acquisitions, divestitures, business integrations and/or restructuring activities. As of December 31, 2024, we had cash and cash equivalents of $468 million and unused borrowing capacity on our Revolving Credit Facility of approximately $750 million. In addition, our Securitization Facility provides for additional borrowing capacity based on our U.S. Net Eligible Receivables Balances. As of December 31, 2024, we had $125 million in undrawn borrowing capacity on this facility. We also have the ability to access capital markets to obtain debt financing for longer-term funding, if required. Further, we believe we have sufficient cash flow and liquidity to remain in compliance with our debt covenants.

We made $1,600 million of term loan debt repayments during the year ended December 31, 2024, utilizing the vast majority of the proceeds from the sale of our aqua business, a portion of the proceeds from our new $350 million Incremental Term Facility due 2031 and available cash on hand. We also repaid $200 million, net on our Revolving Credit Facility and $25 million, net on our Securitization Facility. Combined, these net repayments of $1,475 million during 2024 have significantly reduced our leverage and anticipated future interest expense.

Our ability to meet future funding requirements may be impacted by macroeconomic, business and financial volatility. As market conditions change, we will continue to monitor our liquidity position. However, a challenging economic environment or an economic downturn may impact our liquidity or ability to obtain future financing. See "Item 1A. Risk Factors - We have substantial indebtedness."

Cash Flows

The following table provides a summary of cash flows from operating, investing and financing activities for the years ended December 31, 2024 and 2023:

Operating Activities

Cash provided by operating activities increased $270 million to $541 million for the year ended December 31, 2024, compared to $271 million for the year ended December 31, 2023. The increase in cash provided by operating activities was driven by year-over-year improvements in changes in operating assets and liabilities, partially offset by a decrease of $52 million of cash proceeds from interest rate swap settlements year-over-year.

Investing Activities

Cash provided by investing activities was $1,158 million for the year ended December 31, 2024, and was driven by cash proceeds of $1,294 million from the sale of our aqua business in July 2024, and to a lesser extent, the collection of a $66 million receivable related to the previous divestiture of our Shawnee and Speke facilities. These proceeds from investing activities were partially offset by $147 million of net purchases of property and equipment and software and $36 million of cash paid for the acquisition of the Speke facility (see Note 4. Acquisitions, Divestitures and Other Arrangements to the consolidated financial statements for additional information on current and prior year acquisition and divestiture activities). Cash used for investing activities of $169 million during the year ended December 31, 2023, primarily related to $140 million of cash paid for property and equipment and software and $19 million paid for our acquisitions of NutriQuest and NutriQuest Brazil.

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Financing Activities

Cash used for financing activities was $1,492 million for the year ended December 31, 2024, compared to $83 million for the year ended December 31, 2023. In 2024, we repaid $1,600 million of term loan debt, $200 million, net on our Revolving Credit Facility and $25 million, net on our Securitization Facility. These debt repayments were partially offset by proceeds of $350 million from the issuance of our Incremental Term Facility due 2031 in August 2024. Cash used for financing activities during 2023 primarily reflected the repayment of our previously outstanding 4.272% Senior Notes due 2023, partially offset by $200 million of net borrowings on our Revolving Credit Facility and $125 million of net borrowings on our Securitization Facility. See Note 8. Debt to the consolidated financial statements for further information related to our debt related borrowing and repayment activity.

Capital Expenditures

Capital expenditures, which we define as cash paid for property and equipment and software, were $147 million during 2024, an increase of $7 million compared to 2023. We anticipate capital expenditures in 2025 to be approximately $225 million to $255 million. This anticipated increase in capital expenditures in 2025 compared to recent years is due, in part, to expected capital spend associated with the expansion of our monoclonal antibody manufacturing facility in Elwood, Kansas.

Description of Indebtedness

For a complete description of our debt and available credit facilities as of December 31, 2024, see Note 8. Debt to the consolidated financial statements.

Contractual Obligations

Our contractual obligations and commitments as of December 31, 2024, are primarily comprised of long-term debt obligations, operating leases, including a 25-year lease commitment that will commence in 2025 for our new corporate headquarters in Indianapolis, Indiana, and purchase obligations. Our long-term debt obligations are comprised of our expected principal and interest obligations. Purchase obligations consist of open purchase orders as of December 31, 2024, and contractual payment obligations with significant vendors which are noncancelable and not contingent. These obligations are primarily short-term in nature. See Note 13. Leases to the consolidated financial statements for further discussion regarding our contractual obligations related to leases, including for our new corporate headquarters in Indianapolis, Indiana.

Critical Accounting Estimates

The preparation of financial statements in accordance with GAAP requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures at the date of the financial statements and during the reporting period. Certain of our accounting estimates are considered critical because they are the most important to the fair presentation of our financial statements, including the disclosures thereto, and often require significant, difficult or complex judgments, probabilities and assumptions. While we believe our critical accounting estimates to be reasonable based on all relevant information available, given their inherent uncertainty, if our estimates and assumptions are not representative of actual outcomes, our results could be materially impacted. We regularly evaluate our estimates and assumptions and adjust them when facts and circumstances indicate the need for change, and such changes generally would be reflected in our consolidated financial statements in the period they are determined. We apply estimation methodologies consistently from year to year. The following is a summary of accounting estimates that we consider critical to our consolidated financial statements.

Revenue Recognition

Our gross product revenue is subject to reductions that are generally estimated and recorded in the same period the revenue is recognized and primarily represent revenue incentives (rebates and discounts). For estimates related to revenue incentives, we use our historical experience with similar incentives programs, current sales data and estimates of inventory levels at our channel distributors to estimate the impact of such programs on revenue and continually monitor the impact of this experience and adjust as necessary.

Although the amounts recorded for revenue reductions are dependent on estimates and assumptions, historically our adjustments to actual results have not been material. The sensitivity of our estimates can vary by program, type of customer and geographic location. Amounts recorded for revenue reductions can result from a complex series of judgments about future events and uncertainties and can rely on estimates and assumptions. If any of our ratios, factors, assessments, experiences or judgments are not indicative or accurate predictors of our future experience, our results could be materially affected.

See Note 2. Summary of Significant Accounting Policies and Note 3. Revenue to the consolidated financial statements for further discussion regarding our revenue recognition policy and quantitative information regarding our rebate programs, respectively.

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Acquisitions and Divestitures

Acquisitions

We account for assets acquired and liabilities assumed in a business combination based on their respective fair values as of the acquisition date. The excess of the purchase price over the fair value of the acquired net assets, where applicable, is recorded as goodwill. The judgments made in determining estimated fair values assigned to assets acquired and liabilities assumed, as well as estimated asset lives, can materially affect our consolidated results of operations. The fair values of intangible assets are determined using information available at the acquisition date based on expectations and assumptions that are deemed reasonable by management. These fair value estimates require significant judgment with respect to future revenues and earnings before interest and taxes (EBIT) margins, use of working capital, the selection of appropriate discount rates, product mix, income tax rates and other assumptions and estimates. Such estimates and assumptions are determined based upon our business plans and, when applicable, market participants' views of us and similar companies. We often utilize an income approach, which is a valuation technique that provides an estimate of fair value based on market participant expectations of the cash flows an asset would generate over its remaining useful life. For significant acquisitions, we normally engage an independent valuation specialist to assist in valuing significant assets and liabilities.

Divestitures

Determining the gain or loss on the divestiture of a business under GAAP requires us to allocate a portion of our single reporting unit's goodwill to the divested business' carrying value (the disposal group). The determination of how much goodwill to allocate to a disposal group is based on the relative fair value of the business being sold and the fair value of the remaining reporting unit being retained, which in the case of Elanco, is our remaining consolidated business.

In determining the amount of goodwill to be included in our aqua business disposal group, we compared the fair value of the disposal group, which we determined corresponded with the agreed upon sales price, to the estimated fair value of our single reporting unit as a whole. We estimated the fair value of our single reporting unit using the income approach. Significant management judgment was required in estimating the fair value of our single reporting unit, including, but not limited to, estimates and assumptions regarding future cash flows of our single reporting unit, revenue growth and other profitability measures, such as gross margin and earnings before interest, taxes, depreciation and amortization (EBITDA) margin and the determination of an appropriate discount rate. While we believe the estimates and assumptions underlying our fair value estimates were reasonable in view of all available information, significant changes to any of these significant judgments could have resulted in a different amount of goodwill allocated to our aqua business disposal group, and if so, would have impacted the amount of the pre-tax gain recognized.

Impairment of Goodwill and Indefinite-Lived Assets

Goodwill is not amortized but is reviewed at least annually for impairment during the fourth quarter, or more frequently if there is a significant change in events or circumstances that indicates the fair value of our single reporting unit is more likely than not less than its carrying amount (a "triggering event"). When required, a comparison of fair value to the carrying amount of our reporting unit is performed to determine the amount of impairment, if any. We begin by assessing qualitative factors to determine whether it is more likely than not that the fair value of our single reporting unit is less than its carrying value. Based on that qualitative assessment, if we conclude it is more likely than not that the fair value is less than its carrying value, we conduct a quantitative impairment test, which involves comparing the estimated fair value of our single reporting unit to its carrying value. For quantitative goodwill impairment tests, when required, we estimate the fair value of our single reporting unit using an income approach. If the carrying value of the reporting unit exceeds its estimated fair value, we recognize an impairment loss for the difference. Significant management judgment is required in estimating our reporting unit’s fair value and in the creation of forecasts of future operating results to be used in the discounted cash flow method of the income approach valuation. These include, but are not limited to, estimates and assumptions regarding our future cash flows, revenue growth rates and other profitability measures such as gross margin and EBITDA margin; and the determination of an appropriate discount rate.

Given the sharp increase in long-term treasury rates in the third quarter of 2023, we assessed our long-lived assets for impairment, concluding that a triggering event existed for certain indefinite-lived assets, including goodwill. Accordingly, we performed interim quantitative impairment tests of our goodwill and other indefinite-lived assets, which resulted in a $1,042 million pre-tax goodwill impairment charge. We have closely monitored for additional triggering events since this impairment charge, and the results of our most recent annual review indicated that the estimated fair value of our single reporting unit more likely than not exceeded its carrying amount.

While we believe the estimates and assumptions underlying our annual goodwill impairment review in the fourth quarter of 2024 were reasonable in view of all available information, these assumptions are subject to change in future periods because of, among other things, reductions in our estimates of future cash flows, revenue growth or other profitability measures, and/or an increase in the discount rate, which is highly correlated with long-term

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treasury rates. We have observed long-term treasury rates increase since our annual goodwill impairment review. While we believe, as of December 31, 2024, the current rate environment does not represent a triggering event, based on our best estimates we believe a further 50 basis-point increase in long-term treasury rates could result in a triggering event, and therefore, a quantitative goodwill impairment test. While we cannot say with certainty whether or not such a quantitative test would result in a goodwill impairment, we do believe a 100 basis-point increase, absent any other changes, would likely result in a goodwill impairment charge.

Similar to goodwill, indefinite-lived intangible assets are also reviewed for impairment at least annually during the fourth quarter, or more frequently if there is a triggering event. We also typically use an income approach when estimating the fair value of our indefinite-lived intangible assets, which primarily represent IPR&D acquired from prior business combinations. During the years ended December 31, 2024, 2023 and 2022, we recorded asset impairments related to our indefinite-lived intangibles of $56 million, $6 million and $59 million, respectively. For more information related to our indefinite-lived asset impairment charges, see Note 5. Asset Impairment, Restructuring and Other Special Charges and Note 11. Goodwill and Intangibles to the consolidated financial statements.

Deferred Tax Asset Valuation Allowances

We maintain valuation allowances unless it is more likely than not that all of the deferred tax asset will be realized. Changes in valuation allowances are typically included in our tax provision in the period of change. In determining whether a valuation allowance is warranted, we evaluate factors such as prior earnings history, expected future earnings, carryback and carryforward periods of tax attributes, availability of taxable temporary differences and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. The realizability assessments made at a given balance sheet date are subject to change in the future, particularly if earnings of a subsidiary are significantly higher or lower than expected, or if we take operational or tax planning actions that could impact the future taxable earnings of a subsidiary. A change in these assumptions may result in an increase or decrease in the realizability of our existing deferred tax assets, and therefore a change in the valuation allowance, in future periods. In making such judgments, significant weight is given to evidence that can be objectively verified.

As of December 31, 2024 and 2023, we had valuation allowances of $269 million and $363 million, respectively. In recent years we have incurred pre-tax losses in the U.S. primarily as a result of impairments and transaction, restructuring, integration and other costs. As a result, we have concluded that it is “more likely than not” that a portion of the U.S. deferred assets will not be utilized, and have recorded valuation allowances of $218 million and $289 million, respectively, against these deferred tax assets. Under current tax laws, the valuation allowance will not limit our ability to utilize U.S. deferred tax assets provided we can generate sufficient future taxable income in the U.S. We anticipate we will continue to record a valuation allowance against the losses until such time as we are able to determine it is “more likely than not” that the deferred tax asset will be realized.

Recently Issued Accounting Pronouncements

For discussion of our new accounting standards, see "Item 8. Financial Statements and Supplementary Data — Note 2. Summary of Significant Accounting Policies."

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Introduction

Management’s discussion and analysis of financial condition and results of operations (MD&A) is intended to assist the reader in understanding and assessing significant changes and trends related to our financial position and results of operations. This discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying footnotes in Item 8 of Part II of this Form 10-K. Certain statements in this Item 7 of Part II of this Form 10-K constitute forward-looking statements. Various risks and uncertainties, including those discussed in "Forward-Looking Statements" and Item 1A. “Risk Factors,” may cause our actual results, financial position and cash generated from operations to differ materially from these forward-looking statements.

Business Overview

Elanco is a global leader in animal health, dedicated to innovating and delivering products and services to prevent and treat disease in farm animals and pets. Our diverse, durable product portfolio is sold in more than 90 countries and serves animals across many species, primarily: dogs and cats (collectively, pet health) and cattle, poultry, swine, sheep and aqua (collectively, farm animal). With a heritage dating back to 1954, we consistently innovate to improve the health of animals and to benefit our customers while fostering an inclusive, cause-driven culture for our employees. We operate our business in a single segment, directed at advancing the well-being of animals, people and the planet, enabling us to realize our vision of Food and Companionship Enriching Life.

Our diverse product portfolio of approximately 200 brands helps make us a trusted partner to pet owners, veterinarians and farm animal producers. Our products are generally sold worldwide to third-party distributors and independent retailers, and directly to farm animal producers and veterinarians. In recent years, we have expanded our omnichannel presence in both the veterinary clinic and in retail markets, including e-commerce.

Product Development and Regulatory Update

A key element of our targeted value creation strategy is to drive revenue growth through portfolio development and product innovation. We continue to pursue the development of new chemical and biological molecules, as well as additional registrations and indications for current products. Our future growth and success depend on both our pipeline of new products, including new products we develop internally, develop with partners or that we are able to obtain through licenses or acquisitions, and the life cycle management of our existing products. We believe we are an industry leader in animal health R&D, with a track record of successful product innovation, business development and commercialization. For example, in 2023 we received conditional approval from the USDA and launched our canine parvovirus monoclonal antibody treatment in the U.S. This product is the first and only approved therapeutic solution to treat canine parvovirus, one of the most contagious and deadly viruses to dogs, if not treated.

Seresto: On July 13, 2023, the EPA announced its completion of a comprehensive, multi-year review, with support from the FDA, of the Seresto flea and tick collar and confirmed the continued registration of the collar. As part of the EPA’s scientific review process, the agency analyzed incident data including third-party assessments and compared data to other EPA-registered pet products. Based on comprehensive data from the study, the EPA concluded that Seresto continues to meet all the EPA’s standards for registration under FIFRA, which ensures that products do not pose an unreasonable risk of harm. We believe the EPA's conclusions align with those of authorities worldwide, with Seresto being approved for use in more than 80 countries and supported by veterinary professionals around the globe. The robust scientific evidence continues to support Seresto's safe use.

Other Key Trends and Factors Affecting Our Results of Operations

Acquisition and Integration Activity: In 2023 we acquired certain U.S. marketed products, pipeline products, inventory and an assembled workforce from NutriQuest, LLC (NutriQuest) and certain assets including inventory and distribution rights for certain marketed products from NutriQuest Nutricao Animal Ltda (NutriQuest Brazil). Additionally, as previously disclosed, in April 2023 we successfully completed the integration of the Bayer Animal Health business into our ERP system. We incurred costs totaling $93 million in 2023 related to integration activities, including the build out of processes and systems to support our global organization. We anticipate some additional costs through early 2024 as we finalize these integration activities.

Macroeconomic Factors: Our operations are exposed to and are impacted by various global macroeconomic factors. We face continuing market and operating challenges across the globe due to, among other factors, the Russia-Ukraine conflict, conditions related to the COVID-19 pandemic, supply chain disruption, higher interest rates, foreign currency exchange rate volatility and inflationary pressures. Continued evolution of these conditions has led

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to economic slowdowns in certain countries and/or regions and volatility in consumer behavior. We anticipate global macroeconomic pressures to continue in 2024.

Russia-Ukraine Conflict: As a global animal health leader, we have an obligation to support the health of animals and people. At the center of that work is ensuring access and availability of food and avoiding the spread of disease. At this time, we are limiting our business in Russia to only the essential products that support these needs, while complying with all imposed sanctions. We do not currently manufacture products in Russia, but we continue to support the health of animals and people in the country. We have entered into an agreement pursuant to which we will supply raw material inventories to an entity in Russia that will manufacture its own products, which we will then distribute, because of new laws requiring products sold in Russia to be produced there as well. We do not conduct business with the Russian government. During 2023, revenue from Russian and Ukrainian customers represented approximately 1% of our consolidated revenue. Assets held in Russia as of December 31, 2023, represented less than 1% of our consolidated assets.

Seasonality: While many of our products are sold consistently throughout the year, we do experience seasonality in our pet health business due to increased demand for certain parasiticide product offerings in the first half of the year. For example, based upon historical results, approximately 75% and 60% of total annual revenue contributed by our higher-margin parasiticide products Seresto and Advantage Family, respectively, typically occurs during the first half of the year, which is reflective of the flea and tick season in the Northern Hemisphere.

Goodwill impairment: Given the sharp increase in long-term treasury rates in the third quarter of 2023, we assessed our long-lived assets for impairment, concluding that qualitative impairment indicators (i.e., a triggering event) existed as of September 30, 2023, for certain indefinite-lived assets, including goodwill. Accordingly, we performed an interim quantitative goodwill impairment test. Significant management judgment was required in estimating our reporting unit’s fair value and in the creation of forecasts of future operating results that were used in the discounted cash flow method of the income approach valuation. These included, but were not limited to, estimates and assumptions regarding our future cash flows, revenue growth and other profitability measures such as gross margin and EBITDA margin, and the determination of an appropriate discount rate. We made these significant judgments based on our historical experience, relevant market size, historical pricing and expected industry trends.

Due principally to the sharp increase in long-term treasury rates, which led to an increased discount rate assumption relative to prior assessments, our quantitative test resulted in a $1,042 million pre-tax impairment charge. While we believe the estimates and assumptions underlying our goodwill impairment test were reasonable in view of all available information, and while no further impairment charges were recorded during the fourth quarter of 2023, future changes in our discount rate assumption, whether driven by increases in long-term treasury rates or other factors, or future changes in other significant assumptions or the use of alternative estimates and assumptions, could have a significant impact on our reporting unit's estimated fair value, exposing us to further goodwill impairment losses. For additional information regarding this goodwill impairment, see Note 11. Goodwill and Intangibles to the consolidated financial statements.

Subsequent Events

Announced sale of aqua business: On February 5, 2024, we entered into an agreement to sell our aqua business to a subsidiary of Merck Animal Health for approximately $1.3 billion in cash, payable at closing, which we currently anticipate to occur around mid-year 2024. Our aqua business includes products across both warm-water and cold-water species and generated $175 million in revenue during each of the years ended December 31, 2023 and 2022. Upon closing of this sale, we intend to use the after-tax cash proceeds to accelerate our debt paydown efforts, creating balance sheet flexibility and lower future interest expense, which will allow us to prioritize our investments in larger markets with greater long-term earnings potential. The closing of the agreement is subject to customary closing conditions, including the receipt of applicable antitrust approvals. If the agreement is terminated due to failure to obtain required antitrust approvals, subject to certain conditions, Merck Animal Health will be required to pay us a termination fee of $55 million in cash. See Note 19. Subsequent Events to the consolidated financial statements for further information.

Approved restructuring plan: In February 2024 our Board of Directors authorized a restructuring plan (the restructuring plan) to improve operational efficiencies and better align our organizational structure with current business needs, top strategic priorities and key growth opportunities. Specifically, the restructuring plan is intended to reallocate resources by shifting international resources from farm animal to pet health as we plan for the global launches of certain potential blockbuster products currently under regulatory review. Further, the restructuring plan is expected to result in changes in how we operate in and sell into the Argentina market, among others, which we anticipate will reduce our foreign currency exposure.

The restructuring plan will result in the elimination of approximately 420 personnel across our global organization. Expected pre-tax charges associated with the restructuring plan total $50 to $55 million in 2024, including $40 to $45 million of cash-based severance costs, the majority of which will be paid in 2024. The restructuring plan is expected to result in annualized net savings of $30 to $35 million. See Note 19. Subsequent Events to the consolidated financial statements for further information.

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Results of Operations

The following discussion and analysis of the consolidated statements of operations should be read along with the consolidated financial statements and the notes thereto included in Item 8. Financial Statements and Supplementary Data. For results of operations discussions related to years ended December 31, 2022 and 2021, refer to Item 7 of Part II in our Annual Report on Form 10-K for the year ended December 31, 2022, filed with the SEC on March 1, 2023. Our results of operations for the periods presented below may not be comparable with prior periods or with our results of operations in the future due to many factors, including but not limited to the factors identified in "Key Trends and Factors Affecting Our Results of Operations" above.

Certain amounts and percentages may reflect rounding adjustments.

NM - Not meaningful

Revenue

As a global company, our products are sold in more than 90 countries, and as a result significant portions of our revenue and expenses are recorded in currencies other than the U.S. dollar. As a result, our revenue is influenced by changes in foreign currency exchange rates. For the years ended December 31, 2023 and 2022, approximately 51% of our revenue was denominated in foreign currencies. Foreign currency movements decreased revenue by 1% and 4% for the years ended December 31, 2023 and 2022, respectively, compared to the prior years.

Further, increases or decreases in inventory levels in our distribution channels can positively or negatively impact our revenue results, leading to periodic variations in revenue. This can be a result of various factors, such as end customer demand, new customer contracts, heightened and generic competition, the need for certain inventory levels, our ability to renew distribution contracts with expected terms, our ability to implement commercial strategies, regulatory restrictions, unexpected customer behavior, proactive measures taken by us in response to shifting market dynamics, payment terms we extend, which are subject to internal policies, blackout shipping periods due to system downtime, implementations and integrations and procedures and environmental factors beyond our control.

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On a global basis, our revenue by product category for the years ended December 31 is summarized as follows:

Note: Numbers may not add due to rounding

(1)Constant Currency (CC), a non-GAAP measure, is defined as revenue growth excluding the impact of foreign exchange rates. The calculation assumes the same foreign currency exchange rates that were in effect for the comparable prior year were used in translation of the current period results. We believe this metric provides a useful comparison to previous periods.

(2)Represents revenue from arrangements in which we manufacture products on behalf of a third-party.

On a global basis, the effect of price, foreign currency exchange rates and volumes on changes in revenue for the year ended December 31, 2023, as compared to the prior year, was as follows:

Note: Numbers may not add due to rounding

Pet health revenue decreased $34 million, or 2%, driven by a decrease in volume and an unfavorable impact from foreign exchange rates, partially offset by an increase in price. On a constant currency basis, the decrease of 1% was primarily attributable to declines in demand for retail parasiticide products in Spain and continued competitive pressure on certain products in the U.S. veterinary channel. These factors were partially offset by increased pricing, higher demand for over-the-counter products in the U.S. and increased revenue from new products.

Farm animal revenue increased $52 million, or 2%, driven by an increase in price, which was partially offset by an unfavorable impact from foreign exchange rates. On a constant currency basis, the increase of 4% was primarily attributable to pricing increases, as volumes were flat year over year. Revenue from new products, led by Experior, revenue from our acquisitions of NutriQuest and NutriQuest Brazil and strength in poultry globally were offset by reduced sales of cattle implants due to U.S. regulatory changes, a less favorable environment for sheep due to weather conditions and generic competition.

Cost of Sales

Cost of sales increased $18 million in 2023 as compared to 2022, and cost of sales as a percentage of revenue increased from 43% to 44% year-over-year, reflecting the impact of inflation and planned reduced throughput at certain manufacturing sites in support of efforts to reduce inventory balances on-hand and improve cash conversion.

Research and Development

R&D expenses increased $6 million, or 2%, in 2023 compared to 2022, primarily driven by higher employee-related expenses and project costs.

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Marketing, Selling and Administrative

Marketing, selling and administrative expenses increased $20 million, or 2%, in 2023 compared to 2022, primarily driven by increases in marketing and promotional spend relating to our U.S. Pet Health business and employee-related expenses.

Amortization of Intangible Assets

Amortization of intangible assets increased $20 million in 2023 compared to 2022, due to the addition of amortization of intangible assets recorded from our acquisitions of certain assets of NutriQuest and NutriQuest Brazil in 2023, as well as the impact of foreign currency exchange rates.

Asset Impairment, Restructuring and Other Special Charges

Asset impairment, restructuring and other special charges decreased $56 million in 2023 compared to 2022, primarily due to lower impairment charges and costs associated with the implementation of new systems, programs and processes resulting from the integration of Bayer Animal Health. For additional information regarding our asset impairment, restructuring and other special charges, see Note 5. Asset Impairment, Restructuring and Other Special Charges to the consolidated financial statements.

Goodwill Impairment

As discussed above, due principally to the sharp increase in long-term treasury rates in the third quarter of 2023, which we considered a triggering event, we performed a quantitative goodwill impairment test, which resulted in a $1,042 million pre-tax impairment charge. For additional information, see Note 11. Goodwill and Intangibles to the consolidated financial statements.

Interest Expense, Net of Capitalized Interest

Interest expense, net of capitalized interest increased $36 million in 2023 compared to 2022, primarily due to higher interest rates on our outstanding variable-rate debt and rate increases on our Senior Notes driven by credit downgrades. Interest expense, net of capitalized interest in 2022 included $20 million of debt extinguishment charges, which did not recur in 2023.

Other Expense, Net

Other expense, net increased $43 million in 2023, as compared to 2022, due primarily to settlement provisions recorded in 2023 of $15 million related to the Seresto class action lawsuits and $12.5 million for a possible resolution or settlement with the SEC related to potential disclosure claims (see Note 16. Commitments and Contingencies to the consolidated financial statements for further information). Foreign currency exchange losses were also higher in 2023, as we incurred losses of $50 million, compared to foreign currency exchange losses of

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$38 million in 2022. Foreign currency losses in 2023 included $40 million of transaction losses, of which $25 million related to our affiliate in Argentina, and devaluation losses of $10 million related to the hyperinflationary environments in Turkey and Argentina.

Income Tax Expense

Income tax expense was $36 million in 2023 compared to $6 million in 2022, and the effective tax rate was (3)% in 2023, compared to (8)% in 2022. The negative effective tax rate in 2023 differed from the statutory income tax rate primarily due to the recognition of the aforementioned goodwill impairment charge that was non-deductible for income tax purposes in most of the impacted jurisdictions and an increase in our valuation allowance during the year, primarily attributable to the likelihood of not realizing the benefit of U.S. federal and state deferred tax assets due to pre-tax losses.

Income tax expense for the year ended December 31, 2022, included a $17 million income tax benefit reclassified from accumulated other comprehensive loss due to the termination of interest rate swaps and a $16 million Brazil income tax refund claim resulting from a Brazil Supreme Court decision rendered in 2022 that determined certain Brazil state value-added tax (VAT) incentives were not subject to federal tax. For additional information, see Note 15. Income Taxes to the consolidated financial statements.

Liquidity and Capital Resources

Our primary sources of liquidity are cash on hand, cash flows from operations and funds available under our credit facilities. As a significant portion of our business is conducted internationally, we hold a significant portion of cash outside the U.S. We monitor and adjust the amount of foreign cash based on projected cash flow requirements. Our ability to use foreign cash to fund cash flow requirements in the U.S. may be impacted by local regulations and, to a lesser extent, the income taxes associated with transferring cash to the U.S. We intend to indefinitely reinvest substantially all foreign earnings for continued use in our foreign operations. As our business evolves, we may change that strategy, particularly to the extent we identify tax efficient reinvestment alternatives for our foreign earnings or change our cash management strategy.

We believe our primary sources of liquidity are sufficient to fund our short-term and long-term existing and planned capital requirements, which include working capital obligations, funding existing marketed and pipeline products, capital expenditures, business development in our targeted areas, short-term and long-term debt obligations, such as principal and interest payments, as well as interest rate swaps, operating lease payments, purchase obligations and costs associated with business integrations. As of December 31, 2023, we had cash and cash equivalents of $352 million and unused borrowing capacity on our Revolving Credit Facility of approximately $550 million, of which an incremental $50 million was drawn in February 2024. In addition, we have the ability to access capital markets to obtain debt financing for longer-term funding, if required. Further, we believe we have sufficient cash flow and liquidity to remain in compliance with our debt covenants.

Our ability to meet future funding requirements may be impacted by macroeconomic, business and financial volatility. As market conditions change, we will continue to monitor our liquidity position. However, a challenging economic environment or an economic downturn may impact our liquidity or ability to obtain future financing. See "Item 1A. Risk Factors - We have substantial indebtedness."

Cash Flows

The following table provides a summary of cash flows from operating, investing and financing activities for the periods presented:

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Operating Activities

Cash provided by operating activities decreased $181 million to $271 million for the year ended December 31, 2023, compared to $452 million for the year ended December 31, 2022. The decrease in cash from operating activities primarily related to a decrease of $150 million of proceeds from interest rate swap settlements year-over-year. Additionally, a larger net loss in 2023 (excluding non-cash goodwill and other impairment charges) was partially offset by year-over-year changes in working capital.

Investing Activities

Cash used for investing activities decreased $10 million to $169 million for the year ended December 31, 2023, compared to $179 million for the year ended December 31, 2022. The decrease in cash used for investing activities was primarily driven by a decrease of $31 million in cash paid for property and equipment and software, which was partially offset by cash paid for the acquisitions of certain assets of NutriQuest and NutriQuest Brazil, totaling $19 million, during the year ended December 31, 2023.

Financing Activities

Cash used for financing activities was $83 million for the year ended December 31, 2023, compared to $549 million for the year ended December 31, 2022. In 2023, cash used to repay long-term borrowings totaled $402 million and included the repayment in full of our 4.272% Senior Notes due 2023. These long-term debt repayments were partially offset by $200 million of net borrowings on our Revolving Credit Facility ($350 million in borrowings, net of $150 million in repayments) and $125 million of net borrowings on our new Securitization Facility ($250 million in borrowings, net of $125 million in repayments). Cash used for financing activities during 2022 primarily reflected the tender offer to partially settle the 4.272% Senior Notes due 2023, as well as net repayments on our Revolving Credit Facility and repayment of indebtedness outstanding under our Term Loan B credit facility, partially offset by proceeds from our incremental term facilities issued in 2022. See Note 8. Debt to the consolidated financial statements for further information related to our debt related borrowing and repayment activity.

Capital Expenditures

Capital expenditures, which we define as cash paid for property and equipment and software, were $140 million during 2023, a decrease of $31 million compared to 2022. We anticipate capital expenditures in 2024 to be approximately $180 million to $200 million.

Description of Indebtedness

For a complete description of our debt and available credit facilities as of December 31, 2023, see Note 8. Debt to the consolidated financial statements.

Contractual Obligations

Our contractual obligations and commitments as of December 31, 2023, are primarily comprised of long-term debt obligations, operating leases and purchase obligations. Our long-term debt obligations are comprised of our expected principal and interest obligations. Purchase obligations consist of open purchase orders as of December 31, 2023, and contractual payment obligations with significant vendors which are noncancelable and not contingent. These obligations are primarily short-term in nature. See Note 13. Leases to the consolidated financial statements for further discussion regarding the contractual obligations related to our new corporate headquarters in Indianapolis, Indiana.

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with GAAP requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. These estimates and underlying assumptions can impact all elements of our consolidated financial statements. Certain of our accounting policies are considered critical because these policies are the most important to the fair presentation of our financial statements, including the disclosures thereto, and may require significant, difficult or complex judgments, probabilities and assumptions that we believe to be reasonable, but that can be inherently uncertain. If our estimates and assumptions are not representative of actual outcomes, our results could be materially impacted. We regularly evaluate our estimates and assumptions and adjust them when facts and circumstances indicate the need for change. Such changes generally would be reflected in our consolidated financial statements in the period they are determined. We apply estimation methodologies consistently from year to year. The following is a summary of accounting policies that we consider critical to the consolidated financial statements.

Revenue Recognition

Our gross product revenue is subject to deductions that are generally estimated and recorded in the same period the revenue is recognized and primarily represent revenue incentives (rebates and discounts). For estimates related to our revenue incentives, we use our historical experience with similar incentives programs and current sales data and estimates of inventory levels at our channel distributors to evaluate the impact of such programs on revenue and continually monitor the impact of this experience and adjust as necessary.

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Although the amounts recorded for revenue deductions are dependent on estimates and assumptions, historically our adjustments to actual results have not been material. The sensitivity of our estimates can vary by program, type of customer and geographic location. Amounts recorded for revenue deductions can result from a complex series of judgments about future events and uncertainties and can rely on estimates and assumptions. If any of our ratios, factors, assessments, experiences or judgments are not indicative or accurate predictors of our future experience, our results could be materially affected.

See Note 2. Summary of Significant Accounting Policies and Note 3. Revenue to the consolidated financial statements for further discussion regarding our revenue recognition policy and quantitative information regarding our rebate programs, respectively.

Acquisitions and Fair Value

We account for the assets acquired and liabilities assumed in an acquisition based on their respective fair values as of the acquisition date. The excess of the purchase price over the fair value of the acquired net assets, where applicable, is recorded as goodwill.

The judgments made in determining estimated fair values assigned to assets acquired and liabilities assumed in a business combination, as well as estimated asset lives, can materially affect our consolidated results of operations. The fair values of intangible assets are determined using information available at the acquisition date based on expectations and assumptions that are deemed reasonable by management. These fair value estimates require significant judgment with respect to future revenues and EBIT margins, use of working capital, the selection of appropriate discount rates, product mix, income tax rates and other assumptions and estimates. Such estimates and assumptions are determined based upon our business plans and when applicable, market participants' views of us and other similar companies. For significant acquisitions, we normally engage an independent valuation specialist to assist in valuing significant assets and liabilities.

Impairment of Goodwill and Other Indefinite-Lived Assets

Goodwill and other indefinite-lived intangible assets are not amortized but are reviewed at least annually for impairment during the fourth quarter, or more frequently if there is a significant change in events or circumstances that indicate the fair value of our single reporting unit or other indefinite-lived asset(s) is more likely than not less than its carrying amount (i.e., a "triggering event"). When required, a comparison of fair value to the carrying amount of our asset(s) is performed to determine the amount of impairment, if any. We begin by assessing qualitative factors to determine whether it is more likely than not that the fair value of our single reporting unit or other indefinite-lived asset(s) is less than its carrying value. Based on that qualitative assessment, if we conclude it is more likely than not that the fair value is less than its carrying value, we conduct a quantitative impairment test, which involves comparing the estimated fair value of our single reporting unit or indefinite-lived asset(s) to its carrying value. For goodwill impairment tests, we estimate the fair value of our single reporting unit using an income approach. If the carrying value of the reporting unit exceeds its estimated fair value, we recognize an impairment loss for the difference. We also use an income approach when estimating the fair value of our other indefinite-lived intangible assets, which primarily represent IPR&D acquired from prior business combinations.

Given the sharp increase in long-term treasury rates in the third quarter of 2023, we assessed our long-lived assets for impairment, concluding that a triggering event existed as of September 30, 2023, for certain indefinite-lived assets, including goodwill. Accordingly, we performed interim quantitative impairment tests of our goodwill and other indefinite-lived assets, which resulted in a $1,042 million pre-tax goodwill impairment charge. Significant management judgment was required in estimating our reporting unit’s fair value and in the creation of forecasts of future operating results that were used in the discounted cash flow method of the income approach valuation. These included, but were not limited to, estimates and assumptions regarding our future cash flows, revenue growth and other profitability measures such as gross margin and EBITDA margin; and the determination of an appropriate discount rate. We made these significant judgments based on our historical experience, relevant market size, historical pricing and expected industry trends. While we believe the estimates and assumptions underlying our goodwill impairment test were reasonable in view of all available information, these assumptions are subject to change in future periods because of, among other things, additional information, financial information based on further historical experience, changes in competition, our investment decisions, volatility in foreign currency exchange rates, results of research and development and changes in macroeconomic conditions, including rising long-term treasury rates and inflation. Future changes in our discount rate assumption, whether driven by increases in long-term treasury rates or other factors, or future changes in any of these other significant assumptions or the use of alternative estimates and assumptions, could have a significant impact on our reporting unit's estimated fair value and may expose us to further goodwill impairment losses. For additional information regarding this goodwill impairment, see Note 11. Goodwill and Intangibles to the consolidated financial statements.

Further, during the years ended December 31, 2023, 2022 and 2021, we recorded asset impairments related to our other indefinite-lived intangibles of $6 million, $59 million and $55 million, respectively. For more information related to our indefinite-lived asset impairment charges, see Note 5. Asset Impairment, Restructuring and Other Special Charges to the consolidated financial statements.

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Deferred Tax Asset Valuation Allowances

We maintain valuation allowances unless it is more likely than not that all of the deferred tax asset will be realized. Changes in valuation allowances are typically included in our tax provision in the period of change. In determining whether a valuation allowance is warranted, we evaluate factors such as prior earnings history, expected future earnings, carryback and carryforward periods of tax attributes, amount and availability of taxable temporary differences and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. The realizability assessments made at a given balance sheet date are subject to change in the future, particularly if earnings of a subsidiary are significantly higher or lower than expected, or if we take operational or tax planning actions that could impact the future taxable earnings of a subsidiary. A change in these assumptions may result in an increase or decrease in the realizability of our existing deferred tax assets, and therefore a change in the valuation allowance, in future periods. In making such judgments, significant weight is given to evidence that can be objectively verified.

As of December 31, 2023 and 2022, we had valuation allowances of $363 million and $228 million, respectively. In recent years we have incurred pre-tax losses in the U.S. primarily as a result of impairments and transaction, restructuring, integration and other costs. As a result, we have concluded that it is “more likely than not” that a portion of the U.S. deferred assets will not be utilized, and have recorded valuation allowances of $289 million and $181 million, respectively, against these deferred tax assets. Under current tax laws, the valuation allowance will not limit our ability to utilize U.S. deferred tax assets provided we can generate sufficient future taxable income in the U.S. We anticipate we will continue to record a valuation allowance against the losses until such time as we are able to determine it is “more likely than not” that the deferred tax asset will be realized.

Recently Issued Accounting Pronouncements

For discussion of our new accounting standards, see "Item 8. Financial Statements and Supplementary Data — Note 2. Summary of Significant Accounting Policies."

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION

Introduction

Management’s discussion and analysis of financial condition and results of operations (MD&A) is intended to assist the reader in understanding and assessing significant changes and trends related to our results of operations and financial position. This discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying footnotes in Item 8 of Part II of this Form 10-K. Certain statements in this Item 7 of Part II of this Form 10-K constitute forward-looking statements. Various risks and uncertainties, including those discussed in "Forward-Looking Statements" and Item 1A, “Risk Factors,” may cause our actual results, financial position, and cash generated from operations to differ materially from these forward-looking statements. For results of operations discussions related to years ended December 31, 2021 and 2020, refer to Item 7 of Part II in our Annual Report on Form 10-K for the year ended December 31, 2021 filed with the Securities and Exchange Commission on February 28, 2022.

Overview

Elanco is a global animal health company that develops products for pets and farm animals in more than 90 countries. With a heritage dating back to 1954, we rigorously innovate to improve the health of animals and to benefit our customers while fostering an inclusive, cause-driven culture for our employees. We operate our business in a single segment directed at fulfilling our vision of enriching the lives of people through food, making protein more accessible and affordable, and through pet companionship, helping pets live longer, healthier lives. We advance our vision by offering products in two primary categories: pet health and farm animal.

On August 27, 2021, we acquired KindredBio, a biopharmaceutical company that developed innovative biologics focused on saving and improving the lives of pets. We had previously signed an agreement with KindredBio in the second quarter of 2021 to acquire exclusive global rights to KIND-030, a monoclonal antibody in development for the treatment and prevention of canine parvovirus. The acquisition of KindredBio further accelerates our opportunity for expansion in pet health, notably by expanding our research efforts in dermatology. See Note 6: Acquisitions, Divestitures and Other Arrangements to the consolidated financial statements for additional information on the acquisition. Subsequent to the acquisition date, our consolidated financial statements include the assets, liabilities, operating results and cash flows of KindredBio

On August 1, 2020, we completed the acquisition of Bayer Animal Health. The acquisition expanded our pet health product category, advancing our planned portfolio mix transformation and creating a better balance between our farm animal and pet health product categories. Our product portfolio and pipeline have been enhanced by the addition of Bayer Animal Health, which complements our commercial operations and international infrastructure. See Note 6: Acquisitions, Divestitures and Other Arrangements to the consolidated financial statements for additional information on the acquisition. Subsequent to the acquisition date, our consolidated financial statements include the assets, liabilities, operating results and cash flows of Bayer Animal Health.

We offer a diverse portfolio of approximately 200 brands that make us a trusted partner to pet owners, veterinarians and farm animal producers. Our products are generally sold worldwide to third-party distributors and independent retailers, and directly to farm animal producers and veterinarians. With the acquisition of Bayer Animal Health, we have expanded our presence in retail and e-commerce channels, allowing our customers to shop where and how they want.

A summary of our 2022, 2021 and 2020 revenue and net loss is as follows:

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As a global company, significant portions of our revenue and expenses are recorded in currencies other than the U.S. dollar. Accordingly, in any period, our reported revenue, expenses and resulting earnings (loss) are impacted by changes in the exchange rates of those currencies relative to the U.S. dollar.

Increases or decreases in inventory levels in our distribution channels can positively or negatively impact our quarterly and annual revenue results, leading to variations in revenues. This can be a result of various factors, such as end customer demand, new customer contracts, heightened and generic competition, the need for certain inventory levels, our ability to renew distribution contracts with expected terms, our ability to implement commercial strategies, regulatory restrictions, unexpected customer behavior, proactive measures taken by us in response to shifting market dynamics, payment terms we extend, which are subject to internal policies, blackout shipping periods due to system downtime, implementations and integrations, and procedures and environmental factors beyond our control, including weather conditions and the COVID-19 global pandemic.

Key Trends and Conditions Affecting Our Results of Operations

Industry Trends

The animal health industry, which includes both pets and farm animals, is a growing industry that benefits billions of people worldwide.

We believe that factors influencing growth in demand for pet medicines and vaccines include:

•increased pet ownership globally;

•pets living longer; and

•owners sharing a unique and loving bond with their pets.

As demand for animal protein grows, farm animal health is becoming increasingly important. We believe that factors influencing growth in demand for farm animal medicines and vaccines include:

•two in three people needing improved nutrition;

•increased global demand for protein, particularly poultry and aquaculture;

•natural resource constraints, such as scarcity of arable land, fresh water and increased competition for cultivated land, driving the need for more efficient food production;

•loss of productivity due to farm animal disease and death;

•increased focus on food safety and food security; and

•human population growth, increased standards of living, particularly in many emerging markets, and increased urbanization.

Growth in farm animal nutritional health products (enzymes, probiotics and prebiotics) is influenced, among other factors, by demand for antibiotic alternatives that can promote animal health and increase productivity.

Factors Affecting Our Results of Operations

Global Macroeconomic Environment

Our operations are conducted globally, and we are exposed to and are impacted by various global macroeconomic factors. Global economic conditions continue to create uncertainty, most notably due to the Russia-Ukraine conflict, the COVID-19 pandemic, supply chain disruptions, and rising inflation. Continued evolution of these conditions has led to economic slowdowns in certain countries and/or regions. It has also led to volatility in consumer behavior, which has reduced demand due to consumption decreases and retailer destocking, particularly impacting our parasiticide products. We expect these global macroeconomic factors to continue in 2023.

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Russia-Ukraine Conflict

In February 2022, Russia commenced military action against Ukraine. In response, the U.S. and certain other countries imposed and continue to impose significant sanctions and export controls against Russia, Belarus and certain individuals and entities connected to Russian or Belarusian political, business, and financial organizations. The U.S. and certain other countries could impose further sanctions, trade restrictions, and other retaliatory actions if the conflict continues or worsens. The broader consequences of the conflict, including related inflationary pressures, geopolitical tensions, additional retaliatory actions taken by the U.S. and other countries, and any counter retaliatory actions by Russia or Belarus in response, including, for example, potential cyberattacks or the disruption of energy and commodity exports, are likely to cause regional instability and could materially adversely affect global trade, currency exchange rates, regional economies and the global economy. The situation remains uncertain and it is difficult to predict the impact that the conflict and actions taken in response to the conflict will have on our business; however, they could increase our costs, disrupt our supply chain, reduce our sales and earnings, or otherwise adversely affect our business and results of operations.

As a global animal health leader, we have an obligation to support the health of animals and people. At the center of that work is ensuring access and availability of food and avoiding the spread of disease. At this time, we are limiting our business in Russia to only the essential products that support these needs, while complying with all imposed sanctions. We do not currently manufacture products or source any materials from companies in Russia for use in our products, but that could change because of new laws requiring products sold in Russia to be produced there as well. We do not conduct business with the Russian government. During the year ended December 31, 2022, revenue to Russian and Ukrainian customers represented approximately 2% of our consolidated revenue. Assets held in Russia as of December 31, 2022 represented less than 1% of our consolidated assets.

COVID-19 Pandemic

We continue to closely monitor the impact of the COVID-19 pandemic, including its variants, and the related economic effects on all aspects of our business, including impacts on our operations, supply chain, and customer demand. The extent to which the COVID-19 pandemic may impact our financial condition and results of operations remains uncertain and is dependent on developments that are out of our control, including a resurgence in positive cases, the emergence of new variants, governmental actions in response to the pandemic (for example, the lockdown orders in China that were lifted in late 2022), and the successful administration of effective vaccines and boosters. We cannot predict the impact that the ongoing COVID-19 pandemic will have on our employees, customers, vendors and suppliers; however, the COVID-19 pandemic has had and may continue to have an adverse impact on our business.

Supply Chain

We continue to experience disruption and volatility in our global supply chain network. This disruption, combined with increased demand for key raw materials and labor constraints, has also impacted our suppliers, resulting in shortages of raw materials and components required to manufacture our products. We continue to work closely with suppliers and freight partners to mitigate impacts to our operations and customers, including the addition of new transportation routes, targeted increases of certain safety stocks, and alternative sources of materials. Although we regularly monitor the financial health of companies in our supply chain, prolonged financial hardship on our suppliers and labor shortages could continue to disrupt our ability to obtain key raw materials, adversely affecting our operations. The global industry freight environment has experienced, and could continue to experience, lead time disruptions and high shipping costs, negatively impacting our profitability.

Inflation

We are experiencing, and expect to continue to experience, inflationary pressures due to, among other things, the geopolitical events and macroeconomic factors noted above. Increased inflation rates primarily impact us by increasing our costs, including raw materials, labor, energy, transportation, and other input costs, adversely affecting our profit margins, operating results, and cash flows. In response to these inflationary costs, we have implemented price increases and may implement additional price increases in the future.

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Revision of Prior Period Financial Statements Primarily Relating to Tax Valuation Allowance Adjustment

In connection with the preparation of our financial statements as of and for the year ended December 31, 2022, a cumulative error was identified relating to the valuation allowance for taxes for a Southeast Asia affiliate. While immaterial to prior years, correcting this cumulative error in 2022 would have caused the 2022 financial statements to be materially misstated. Therefore, immaterial revisions in relation to this item were made to our financial statements as of and for the years ended December 31, 2021 and 2020. The correction of this error was immaterial to our financial statements for those years.

As a result of having to make the revisions related to this error, we made other immaterial revisions to the consolidated financial statements as of and for the years ended December 31, 2021 and 2020. All of the revisions are reflected throughout this Form 10-K. See Note 2: Revision of Previously Issued Consolidated Financial Statements to the consolidated financial statements for additional information.

Acquisitions of Bayer Animal Health and KindredBio

We have incurred expenses in connection with our acquisitions of Bayer Animal Health and KindredBio, including fees for professional services such as legal, accounting, consulting, and other advisory fees and expenses. Expenses incurred in 2022 and 2021 are primarily related to integration activities. In addition, we have incurred and expect to continue to incur costs related to the build out of processes and systems to support finance and global supply and logistics and to expand administrative functions, including, but not limited to, information technology, facilities management, distribution, human resources, and manufacturing, to replace services previously provided by the former parent company of Bayer Animal Health. We anticipate that these additional costs will be partially offset by expected synergies. The ERP system integration of legacy Bayer Animal Health to the Elanco system is expected to be completed early in the second quarter of 2023. As a result, there may be a timeframe during which inventory shipments cannot occur. In response to this, we have built some additional inventory as of December 31, 2022 and expect to continue to increase our inventories on hand to ensure that our product is available to customers. Alternatively, we anticipate that certain customers may modify purchasing habits, which would cause a shift of revenue from the second quarter to the first quarter of 2023. In addition, we started extending payment terms in 2023 and may need to continue to extend payment terms to certain customers depending on the estimated timeframe during which shipments cannot occur and based on geography.

Product Development and New Product Launches

A key element of our targeted value creation strategy is to drive growth through portfolio development and product innovation. We continue to pursue the development of new chemical and biological molecules through our approach to innovation. Our future growth and success depend on both our pipeline of new products, including new products that we develop internally and may develop through joint ventures and products that we are able to obtain through licenses or acquisitions, and the expansion of the use of our existing products. We believe we are an industry leader in animal health R&D, with a track record of product innovation, business development and commercialization.

Competition

We face intense competition. Principal methods of competition vary depending on the particular region, species, product category, or individual product. Some of these methods include product quality, price, cost-effectiveness, promotional effectiveness, new product development and product differentiation. Certain products, both existing and new products that we introduce, may compete with other branded or generic products already on the market or that are later developed by competitors. See "Item 1. Business — Competition."

Productivity

Our results during the periods presented have benefited from operational and productivity initiatives implemented following recent acquisitions and in response to changing market demand for antibiotics and other headwinds.

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Our acquisitions in the six years prior to the acquisition of Bayer Animal Health added, in the aggregate, $1.4 billion in revenue, 4,600 full-time employees, and 12 manufacturing and eight R&D sites. The acquisitions of Bayer Animal Health on August 1, 2020 and KindredBio on August 27, 2021 added 3,950 full-time employees, 10 manufacturing sites, and five R&D sites (before company-wide restructuring activities initiated in 2020 and 2021). In addition, from 2015 to 2022, changing market demand for antibiotics and other headwinds, such as competition with generics and innovation, affected some of our highest gross margin products, resulting in a change to our product mix and driving operating margin lower. In response, we implemented a number of initiatives across the manufacturing, R&D and marketing, selling and administrative functions. Our manufacturing cost savings strategies included improving manufacturing processes and headcount through lean manufacturing (minimizing waste while maintaining productivity), closing and selling manufacturing sites, consolidating our CMO network, strategically insourcing certain projects, and pursuing cost savings opportunities through alternate sources of supply. Additional cost savings have resulted from reducing the number of R&D sites, sales force consolidation and reducing discretionary and other general and administrative operating expenses.

Foreign Exchange Rates

Significant portions of our revenue and costs are exposed to changes in foreign exchange rates. Our products are sold in more than 90 countries and, as a result, our revenue is influenced by changes in foreign exchange rates. For the years ended December 31, 2022 and 2021, approximately 51% of our revenue was denominated in foreign currencies. As we operate in multiple foreign currencies, including the Euro, British pound, Swiss franc, Brazilian real, Australian dollar, Japanese yen, Canadian dollar, Chinese yuan, and other currencies, changes in those currencies relative to the U.S. dollar impact our revenue, cost of sales and expenses, and consequently, net income. These fluctuations may also affect the ability to buy and sell our products between markets impacted by significant exchange rate variances. Currency movements decreased revenue by approximately 4% during the year ended December 31, 2022. Currency movements increased revenue by approximately 1% and decreased revenue by approximately 1% during the years ended December 31, 2021 and 2020, respectively.

Components of Revenue and Costs and Expenses

Revenue

Our revenue is primarily derived from a diversified portfolio of products across species consisting of dogs and cats (collectively, pet health) and cattle, poultry, swine and aqua (collectively, farm animal). We market our products to veterinarians, pet owners, and farm animal producers, then sell directly or indirectly through third-party distributors, retailers, or e-commerce outlets. For additional information regarding our products, including descriptions of our product categories, see "Item 1. Business — Commercial Operations" and "Item 1. Business — Products."

Costs, Expenses and Other

Cost of sales consists primarily of cost of materials, facilities and other infrastructure used to manufacture our products, shipping and handling, inventory losses and expired products.

R&D expenses consist of project costs specific to new product R&D and product lifecycle management, overhead costs associated with R&D operations, regulatory, product registrations and investments that support local market clinical trials for approved indications. We manage overall R&D based on our strategic opportunities and do not disaggregate our R&D expenses incurred by nature or by product as we do not use or maintain such information in managing our business.

Marketing, selling and administrative expenses consist of, among other things, the costs of marketing, promotion and advertising and the costs of administration (business technology, facilities, legal, finance, human resources, business development, external affairs and procurement).

Amortization of intangible assets consists of the amortization expense for intangible assets that have been acquired through business combinations and other business development arrangements.

Asset impairment, restructuring and other special charges consist primarily of severance costs resulting from actions taken as part of our productivity initiatives and to reduce our costs; long-lived asset impairment charges and write-downs primarily related to product rationalizations, site closures, the sale of manufacturing sites; transaction

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and integration costs from acquired businesses and other related expenses, primarily Bayer Animal Health; costs associated with the acquisition of KindredBio; and costs related to the build out of processes and systems to support finance and global supply and logistics, among others.

Interest expense, net of capitalized interest consists of interest incurred on our debt.

Other (income) expense, net consists primarily of various items including net (gains)/losses on asset disposals, realized and unrealized foreign exchange translation (gains)/losses, (gains)/losses on equity investments, and loss or impairment on other investments.

Comparability of Historical Results

Our historical results of operations for the periods presented may not be comparable with prior periods or with our results of operations in the future due to many factors, including but not limited to the factors identified in "Key Trends and Conditions Affecting Our Results of Operations."

Results of Operations

The following discussion and analysis of the consolidated statements of operations should be read along with the consolidated financial statements and the notes thereto included elsewhere in this report. For more information, see Note 3: Basis of Presentation to the consolidated financial statements.

Certain amounts and percentages may reflect rounding adjustments.

NM - Not meaningful

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Disaggregated Revenue

On a global basis, our revenue by product category for the years ended December 31 is summarized as follows:

Note: Numbers may not add due to rounding

(1)Represents revenue from arrangements in which we manufacture products on behalf of a third party, including supply agreements associated with divestitures of products related to the acquisition of Bayer Animal Health.

On a global basis, the effect of price, foreign exchange rates and volumes on changes in revenue as compared to the prior year was as follows:

Note: Numbers may not add due to rounding

(1)Constant exchange rate (CER), a non-GAAP measure, is defined as revenue growth excluding the impact of foreign exchange. The calculation assumes the same foreign currency exchange rates that were in effect for the comparable prior-year period were used in translation of the current period results. We believe this metric provides a useful comparison to previous periods.

(2)Impact of 2021 revenue from Bayer Animal Health is reflected in volume.

Revenue

Pet Health revenue decreased by $212 million or 9%, driven by a decrease in volume and an unfavorable impact from foreign exchange rates, partially offset by an increase in price. On a constant currency basis, the decrease of 5% was primarily attributable to lower demand as a result of increased competition impacting certain parasiticide products as well as the overall deterioration in global macroeconomic conditions, which particularly impacted sales of over-the-counter U.S. parasiticide products. The impact was partially offset by growth in our global pain portfolio.

Farm Animal revenue decreased by $113 million or 5%, driven by an unfavorable impact from foreign exchange rates and a decrease in volume, partially offset by an increase in price. On a constant currency basis, revenue was flat year over year. Growth driven by increased demand for aqua products and the contribution from innovation was offset by a continued decline in swine, particularly driven by market conditions in Asia and to a lesser extent competition in Europe, as well as the impact of generic competition for certain cattle brands and the impact of supply chain disruptions.

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Contract Manufacturing revenue decreased by $28 million to $54 million and represented 1% of total revenue.

Cost of Sales

Cost of sales as a percentage of revenue decreased in 2022 as compared to 2021 primarily due to amortization of the fair value adjustment of $64 million recorded from the acquisition of Bayer Animal Health in 2021. Excluding the $64 million fair value adjustment for the year ended December 31, 2021, cost of sales as a percentage of revenue would have been approximately 43%, consistent with 2022. Cost of sales decreased in 2022 primarily due to lower revenue, improvements in manufacturing productivity and the impact of foreign exchange, partially offset by inflationary impacts on input costs, freight, and conversion costs as well as unfavorable product mix.

Research and Development

R&D expenses decreased $48 million to $321 million in 2022 as compared to 2021. R&D expenses in the current year were favorably impacted by cost savings realized as a result of 2021 restructuring activities, lower professional services costs due the rationalization of certain R&D projects, and the impact of foreign exchange.

Marketing, Selling and Administrative

Marketing, selling and administrative expenses decreased $138 million in 2022 compared to 2021, primarily driven by disciplined cost management across the business, cost savings realized as a result of 2021 restructuring activities, a decrease in advertising and promotional costs, and the impact of foreign exchange, partially offset by increases in legal expenses during the period.

Amortization of Intangible Assets

Amortization of intangible assets decreased $28 million to $528 million in 2022 as compared to 2021, primarily due to the impact of foreign exchange rates.

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Asset Impairment, Restructuring and Other Special Charges

For additional information regarding our asset impairment, restructuring and other special charges, see Note 7: Asset Impairment, Restructuring and Other Special Charges to the consolidated financial statements.

Asset impairment, restructuring and other special charges decreased $451 million to $183 million in 2022 as compared to 2021, due in part to a $177 million year over year decrease in severance charges and overall acquisition-related expenses. Also contributing to the decrease were certain nonrecurring charges recorded during 2021, including a $279 million charge to write down assets at our Shawnee and Speke manufacturing sites that were classified as held for sale to an amount equal to fair value less costs to sell, $66 million of impairment charges for intangible assets that were subject to product rationalization, a $26 million charge to establish a liability for future royalty and milestone payments relating to our canine parvovirus license agreement with KindredBio, and an $8 million charge related to a litigation settlement for a matter that originated prior to our acquisition of Bayer Animal Health. These decreases were partially offset by $29 million of nonrecurring pension curtailment gains recorded during 2021 as well as a $22 million asset write-down charge recorded upon the final sale of our Speke manufacturing site and a one-time charge of $59 million related to the expensing of an IPR&D asset licensed from BexCaFe, LLC (BexCaFe) during 2022. See Note 6: Acquisitions, Divestitures and Other Arrangements for further discussion.

Interest Expense, Net of Capitalized Interest

Interest expense increased $5 million to $241 million in 2022, primarily due to $20 million in debt extinguishment losses recorded upon the retirement of a portion of the aggregate principal on our 4.272% Senior Notes due August 28, 2023 and our Term Loan B during the year and higher interest on variable-rate debt due to rate increases, partially offset by a lower average debt balance and the favorable impact of refinancing at lower interest rates.

Other (Income) Expense, Net

Other expense increased $27 million in 2022 as compared to 2021, primarily due to a $14 million increase in foreign exchange losses and a $14 million decrease in up-front payments received and milestones earned from business development arrangements.

Other expense recorded during 2022 primarily consisted of foreign exchange losses and mark-to-market adjustments on equity investments, partially offset by up-front payments received in relation to license and asset assignment agreements, the gain recognized on the disposal of our microbiome R&D platform, and certain components of net periodic benefit cost. See Note 19: Retirement Benefits to the consolidated financial statements for further discussion related to net periodic benefit cost (income) recorded during the period. Other expense recorded during 2021 primarily consisted of mark-to-market adjustments on equity investments and foreign exchange losses, partially offset by gains on divestitures, certain components of net periodic benefit income, an up-front payment received in relation to an asset assignment agreement, a milestone earned in relation to an existing asset sale agreement, and up-front payments received, milestones earned, and equity issued to us in relation to a license agreement.

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Income Tax Expense (Benefit)

Our historical income tax expense may not be indicative of our future expected tax rate. See “Comparability of Historical Results” for further discussion.

Income tax expense was $6 million in 2022 compared to an income tax benefit of $88 million in 2021. The change was primarily due to an increase in taxes on international operations driven by increased taxable income as well as an increase in state taxes in separate filing states offset by other decreases, including a $16 million Brazil income tax refund claim resulting from a Supreme Court decision rendered in 2022 that determined certain Brazil state valued-added tax (VAT) incentives were not subject to federal tax, a $17 million tax benefit due to the termination of interest rate swaps and a $12 million net reduction in taxes associated with the divestiture of the Speke manufacturing site. See Note 16: Income Taxes to our consolidated financial statements for further discussion.

Liquidity and Capital Resources

Our primary sources of liquidity are cash on hand, cash flows from operations and funds available under our credit facilities. As a significant portion of our business is conducted internationally, we hold a significant portion of cash outside of the U.S. We monitor and adjust the amount of foreign cash based on projected cash flow requirements. Our ability to use foreign cash to fund cash flow requirements in the U.S. may be impacted by local regulations and, to a lesser extent, following U.S. tax reforms, the income taxes associated with transferring cash to the U.S. We intend to indefinitely reinvest foreign earnings for continued use in our foreign operations. See Note 16: Income Taxes to the consolidated financial statements for further discussion. As our business evolves, we may change that strategy, particularly to the extent we identify tax efficient reinvestment alternatives for our foreign earnings or change our cash management strategy.

We believe our primary sources of liquidity are sufficient to fund our short-term and long-term existing and planned capital requirements, which include working capital obligations, funding existing marketed and pipeline products, capital expenditures, business development in our targeted areas, short-term and long-term debt obligations which include principal and interest payments as well as interest rate swaps, operating lease payments, purchase obligations, and costs associated with the integration of Bayer Animal Health. In addition, we have the ability to access capital markets to obtain debt refinancing for longer-term funding, if required, to service our long-term debt obligations. Further, we believe we have sufficient cash flow and liquidity to remain in compliance with our debt covenants.

Our ability to meet future funding requirements may be impacted by macroeconomic, business and financial volatility. As markets change, we will continue to monitor our liquidity position. However, a challenging economic environment or an economic downturn may impact our liquidity or ability to obtain future financing. See "Item 1A. Risk Factors - We may not be able to generate sufficient cash to service all of our indebtedness and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful."

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Cash Flows

The following table provides a summary of cash flows from operating, investing and financing activities for the periods presented:

Operating Activities

Our cash flow from operating activities decreased $31 million to $452 million for the year ended December 31, 2022 from $483 million for the year ended December 31, 2021. The decrease is primarily the result of a decrease in cash due to changes in operating assets and liabilities, particularly accounts receivable, inventories, and other assets, as compared to the prior year. This decrease was partially offset by a decrease in net loss after adjusting for non-cash items, as well as proceeds of $207 million from interest rate swap settlements in the current year. Due to the system integration scheduled to be completed in April 2023, we have and may need to further increase inventories on hand and extend payment terms for some customers during the first and second quarters of 2023 to ensure that our product is available for a period of time during which there may be no shipments. In the past, we have extended our payment terms for distributors on occasion. Although we presently have no plans to do so in the future, except for those related to the system integration described above, it is also possible that we will need to extend payment terms in certain situations as a result of the COVID-19 global health pandemic, competitive pressures, macroeconomic factors and the need for certain inventory levels in our distribution channels to avoid supply disruptions. If so, such extensions of customer payment terms could result in additional uses of our cash flow.

Investing Activities

Our cash flow used for investing activities decreased $351 million to $179 million for the year ended December 31, 2022 compared to $530 million for the year ended December 31, 2021. The decrease was primarily driven by cash paid for the acquisition of KindredBio during the year ended December 31, 2021, as well as a year over year decrease in cash paid for purchases of intangible assets. These decreases were partially offset by a year over year increase in cash used for purchases of property and equipment.

Financing Activities

Our cash used in financing activities was $549 million for the year ended December 31, 2022 compared to cash provided by financing activities of $210 million for the year ended December 31, 2021. Cash used for financing activities during 2022 primarily reflected the tender offer completed during the year as well as net repayments on our revolving credit facility and the repayment of indebtedness outstanding under our term loan B credit facility, partially offset by proceeds from our newly issued incremental term facilities. Cash provided by financing activities during 2021 primarily reflected proceeds from our borrowings under our debt financing arrangement with Farm Credit Mid-America, PCA, net proceeds from our revolving credit facility, and $64 million of funding received from the developer in connection with the construction of our new corporate headquarters in Indianapolis, Indiana, partially offset by the repayment of indebtedness outstanding under our Senior Notes.

Capital Expenditures and Software Purchases

Capital expenditures were $137 million during 2022, an increase of $11 million compared to 2021. Purchases of software were $34 million during 2022, an increase of $1 million compared to 2021. We expect 2023 capital expenditures and software purchases to be approximately $165 million to $190 million.

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Description of Indebtedness

For a complete description of our debt and available credit facilities as of December 31, 2022, see Note 10: Debt to the consolidated financial statements.

Contractual Obligations

Our contractual obligations and commitments as of December 31, 2022 are primarily comprised of long-term debt obligations, operating leases, and purchase obligations. Our long-term debt obligations are comprised of our expected principal and interest obligations. Purchase obligations consist of open purchase orders as of December 31, 2022 and contractual payment obligations with significant vendors which are noncancelable and are not contingent. These obligations are primarily short-term in nature. See Note 14: Leases to the consolidated financial statements for further discussion regarding the contractual obligations related to our new corporate headquarters in Indianapolis, Indiana.

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with U.S. GAAP requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Certain of our accounting policies are considered critical because these policies are the most important to the depiction of our financial statements and require significant, difficult or complex judgments by us, often requiring the use of estimates about the effects of matters that are inherently uncertain. Actual results that differ from our estimates could have an unfavorable effect on our financial position and results of operations. We apply estimation methodologies consistently from year to year. The following is a summary of accounting policies that we consider critical to the consolidated financial statements.

Revenue Recognition

Our gross product revenue is subject to deductions that are generally estimated and recorded in the same period that the revenue is recognized and that primarily represent revenue incentives (rebates and discounts) and sales returns. For example:

•for revenue incentives, we use our historical experience with similar incentives programs and current sales data and estimates of inventory levels at our channel distributors to evaluate the impact of such programs on revenue and continually monitor the impact of this experience and adjust as necessary; and

•for sales returns, we consider items such as: local returns policies and practices; returns as a percentage of revenue; an understanding of the reasons for past returns; estimated shelf life by product; and estimates of the amount of time between shipment and return to estimate the impact of sales returns.

If any of our ratios, factors, assessments, experiences or judgments are not indicative or accurate predictors of our future experience, our results could be materially affected.

Although the amounts recorded for these revenue deductions are dependent on estimates and assumptions, historically our adjustments to actual results have not been material. The sensitivity of our estimates can vary by program, type of customer and geographic location. Amounts recorded for revenue deductions can result from a complex series of judgments about future events and uncertainties and can rely on estimates and assumptions.

See Note 4: Summary of Significant Accounting Policies and Note 5: Revenue to the consolidated financial statements for further discussion regarding our revenue recognition policy and quantitative information regarding our rebate programs, respectively.

Acquisitions and Fair Value

We account for the assets acquired and liabilities assumed in an acquisition based on their respective fair values as of the acquisition date. The excess of the purchase price over the fair value of the acquired net assets, where applicable, is recorded as goodwill.

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The judgments made in determining estimated fair values assigned to assets acquired and liabilities assumed in a business combination, as well as estimated asset lives, can materially affect our consolidated results of operations. The fair values of intangible assets are determined using information available at the acquisition date based on expectations and assumptions that are deemed reasonable by management. These fair value estimates require significant judgment with respect to future revenues and EBIT margins, use of working capital, the selection of appropriate discount rates, product mix, income tax rates and other assumptions and estimates. Such estimates and assumptions are determined based upon our business plans and when applicable, market participants' views of us and other similar companies. Depending on the facts and circumstances, we may deem it necessary to engage an independent valuation expert to assist in valuing significant assets and liabilities.

Impairment of Indefinite-Lived and Long-Lived Assets

We review the carrying value of long-lived assets (both intangible and tangible) for potential impairment on a periodic basis and whenever events or changes in circumstances indicate the carrying value of an asset (or asset group) may not be recoverable. We identify impairment by comparing the projected undiscounted cash flows to be generated by the asset (or asset group) to its carrying value. If an impairment is identified, a loss is recorded that is equal to the excess of the asset's carrying value over its fair value generally utilizing a discounted cash flow analysis, and the cost basis is adjusted.

Goodwill and indefinite-lived intangible assets are reviewed for impairment at least annually and when certain impairment indicators are present. We have historically performed our annual goodwill and indefinite-lived intangible asset impairment assessment as of the last day of the fourth fiscal quarter of each year. During the fourth quarter of 2022, we elected to change the date of our annual impairment assessment from December 31st to October 1st. The change was made to more closely align the impairment assessment date with our annual planning and budgeting process as well as our long-term planning and forecasting process. We have determined that this change in accounting principle is preferable and will not affect the consolidated financial statements. Pursuant to this change in accounting principle, in 2022 we performed an impairment assessment as of the first day of our fourth fiscal quarter. The change in impairment assessment date did not delay or avoid an impairment charge. This change is not applied retrospectively as it is impracticable to do so because retrospective application would require application of significant estimates and assumptions with the use of hindsight. Accordingly, the change has been applied prospectively.

When required, a comparison of fair value to the carrying amount of assets is performed to determine the amount of any impairment. In the third quarter of 2022, a significant change in our market capitalization relative to our book value, among other factors, triggered an impairment review. Based on our qualitative assessment, we concluded that it was more likely than not that the fair value of our single reporting unit was less than its carrying value, and therefore, we were required to perform a quantitative goodwill impairment test, which involved comparing the estimated fair value of our single reporting unit with its carrying value, including goodwill. As a result of the quantitative assessment, we concluded that no impairment existed with respect to our goodwill because the estimated fair value of our single reporting unit exceeded the carrying amount by more than 20%. Given the general worldwide economic conditions, we reevaluated our impairment testing from a qualitative perspective as December 31, 2022, which did not result in a change to our previous conclusion that no impairment exists.

Significant management judgment is required in estimating fair values in our impairment reviews and in the creation of forecasts of future operating results that are used in the discounted cash flow method of valuation. These include, but are not limited to, estimates and assumptions regarding (1) our future cash flows, revenue, and other profitability measures such as gross margin and EBITDA margin, (2) the long-term growth rate of our business, and (3) the determination of our weighted-average cost of capital, which is a factor in determining the discount rate. We make these judgments based on our historical experience, relevant market size, historical pricing of similar products, and expected industry trends. These assumptions are subject to change in future periods because of, among other things, additional information, financial information based on further historical experience, changes in competition, our investment decisions, volatility in foreign currency exchange rates, results of research and development, and changes in macroeconomic conditions, including rising interest rates and inflation. A change in these assumptions or the use of alternative estimates and assumptions could have a significant impact on the estimated fair value and may expose us to impairment losses.

During the years ended December 31, 2022, 2021 and 2020, we recorded asset impairments of $60 million, $66 million and $17 million, respectively. For more information related to our impairment charges, see Note 7: Asset Impairment, Restructuring and Other Special Charges to the consolidated financial statements.

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Deferred Tax Asset Valuation Allowances

We maintain valuation allowances unless it is more likely than not that all of the deferred tax asset will be realized. Changes in valuation allowances are typically included in our tax provision in the period of change. In determining whether a valuation allowance is warranted, we evaluate factors such as prior earnings history, expected future earnings, carryback and carryforward periods, amount and availability of taxable temporary differences, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. The realizability assessments made at a given balance sheet date are subject to change in the future, particularly if earnings of a subsidiary are significantly higher or lower than expected, or if we take operational or tax planning actions that could impact the future taxable earnings of a subsidiary. A change in these assumptions may result in an increase or decrease in the realizability of our existing deferred tax assets, and therefore a change in the valuation allowance, in future periods. Concluding that a valuation allowance is not required is difficult when there is significant negative evidence which is objective and verifiable, such as cumulative losses in recent years. We prepare a three-year cumulative pre-tax book income or loss analysis adjusted for certain permanent book to tax differences as a measure of our cumulative results in recent years. In the U.S. and certain foreign jurisdictions, our analysis indicates that we have cumulative three-year historical losses on this basis. This is considered significant negative evidence which is objective and verifiable and therefore, difficult to overcome. However, the three-year cumulative loss position is not solely determinative and accordingly, we consider all other available positive and negative evidence in our analysis. In making such judgments, significant weight is given to evidence that can be objectively verified.

As of December 31, 2022 and 2021, we had valuation allowances of $228 million and $182 million, respectively. In recent years we have incurred pre-tax losses in the U.S. primarily as a result of transaction, restructuring, integration and other costs. As a result, we have concluded that it is “more likely than not” that a portion of the U.S. deferred assets will not be utilized, and have recorded valuation allowances of $181 million and $162 million, respectively, against these deferred tax assets. Under current tax laws, the valuation allowance will not limit our ability to utilize U.S. deferred tax assets provided we can generate sufficient future taxable income in the U.S. We anticipate that we will continue to record a valuation allowance against the losses until such time as we are able to determine it is “more likely than not” that the deferred tax asset will be realized.

Recently Issued Accounting Pronouncements

For discussion of our new accounting standards, see "Item 8. Financial Statements and Supplementary Data — Note 4: Summary of Significant Accounting Policies - Implementation of New Financial Accounting ."

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION

Introduction

Management’s discussion and analysis of financial condition and results of operations (MD&A) is intended to assist the reader in understanding and assessing significant changes and trends related to our results of operations and financial position. This discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying footnotes in Item 8 of Part II of this Form 10-K. Certain statements in this Item 7 of Part II of this Form 10-K constitute forward-looking statements. Various risks and uncertainties, including those discussed in "Forward-Looking Statements" and Item 1A, “Risk Factors,” may cause our actual results, financial position, and cash generated from operations to differ materially from these forward-looking statements. For results of operations discussions related to years ending December 31, 2020 and 2019, refer to Item 7 of Part II in our Annual Report on Form 10-K for the year ended December 31, 2020 filed with the Securities and Exchange Commission on March 1, 2021.

Overview

Elanco is a global animal health company that develops products for pets and farm animals in more than 90 countries. With a heritage dating back to 1954, we rigorously innovate to improve the health of animals and to benefit our customers while fostering an inclusive, cause-driven culture for our employees. We operate our business in a single segment directed at fulfilling our vision of enriching the lives of people through food, making protein more accessible and affordable, and through pet companionship, helping pets live longer, healthier lives.

On August 27, 2021, we acquired KindredBio, a biopharmaceutical company that develops innovative biologics focused on saving and improving the lives of pets. We had previously signed an agreement with KindredBio in the second quarter of 2021 to acquire exclusive global rights to KIND-030, a monoclonal antibody in development for the treatment and prevention of canine parvovirus. The acquisition of KindredBio further accelerates our opportunity for expansion in pet health, notably by expanding our research efforts in dermatology. See Note 5: Acquisitions and Divestitures to the consolidated financial statements for additional information on the acquisition. Subsequent to the acquisition date, our consolidated financial statements include the assets, liabilities, operating results and cash flows of KindredBio

On August 1, 2020, we completed the acquisition of Bayer Animal Health. The acquisition expanded our pet health product category, advancing our planned portfolio mix transformation and creating a better balance between our farm animal and pet health product categories. Our product portfolio and pipeline have been enhanced by the addition of Bayer Animal Health, which complements our commercial operations and international infrastructure. See Note 5: Acquisitions and Divestitures to the consolidated financial statements for additional information on the acquisition. Subsequent to the acquisition date, our consolidated financial statements include the assets, liabilities, operating results and cash flows of Bayer Animal Health.

We offer a diverse portfolio of approximately 200 brands that make us a trusted partner to pet owners, veterinarians and farm animal producers. Our products are generally sold worldwide to third-party distributors, independent retailers, and directly to farm animal producers and veterinarians. With the acquisition of Bayer Animal Health, we have expanded our presence in retail and e-commerce channels in order to meet pet owners where they want to purchase.

A summary of our 2021, 2020, and 2019 revenue and net income (loss) is as follows:

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Increases or decreases in inventory levels at our channel distributors can positively or negatively impact our quarterly and annual revenue results, leading to variations in revenues. This can be a result of various factors, such as end customer demand, new customer contracts, heightened and generic competition, the need for certain inventory levels, our ability to renew distribution contracts with expected terms, our ability to implement commercial strategies, regulatory restrictions, unexpected customer behavior, proactive measures taken by us in response to shifting market dynamics, payment terms we extend, which are subject to internal policies, and procedures and environmental factors beyond our control, including weather conditions and the COVID-19 global pandemic.

Key Trends and Conditions Affecting Our Results of Operations

The animal health industry, which focuses on both pets and farm animals, is a growing industry that benefits billions of people worldwide.

We believe that factors influencing growth in demand for pet medicines and vaccines include:

•increased pet ownership globally;

•pets living longer; and

•increased pet spending as pets are viewed as members of the family by owners.

As demand for animal protein grows, farm animal health is becoming increasingly important. Factors influencing growth in demand for farm animal medicines and vaccines include:

•two in three people needing improved nutrition;

•increased global demand for protein, particularly poultry and aquaculture;

•natural resource constraints, such as scarcity of arable land, fresh water and increased competition for cultivated land, driving the need for more efficient food production;

•loss of productivity due to farm animal disease and death;

•increased focus on food safety and food security; and

•human population growth, increased standards of living, particularly in many emerging markets, and increased urbanization.

Growth in farm animal nutritional health products (enzymes, probiotics and prebiotics) is influenced, among other factors, by demand for antibiotic alternatives that can promote animal health and increase productivity.

Factors Affecting Our Results of Operations

COVID-19 Pandemic and Resulting Operating Environment

Our business has been impacted by the COVID-19 pandemic. We continue to monitor the global outbreak of COVID-19 and have worked with our customers, employees, suppliers and other stakeholders to mitigate the risks posed by its spread. The COVID-19 pandemic continues to impact the economy in the U.S. and globally, and has affected the operations of our company, vendors and suppliers, and supply of and demand for our products as follows:

Operations

As a result of the COVID-19 pandemic, governmental authorities implemented measures to try to contain the virus, such as travel bans and restrictions, limits on gatherings, quarantines, shelter-in-place orders, site closures and business shutdowns. These measures have affected the ability of our employees, vendors, and suppliers to perform their respective responsibilities and obligations relative to the conduct of our business. We have important manufacturing operations worldwide that have been impacted by the outbreak. Measures requiring business shutdowns generally exclude certain essential services, and those essential services commonly include critical infrastructure and the businesses that support that critical infrastructure. Because the animal health industry has been designated an essential business, our manufacturing and research facilities remain operational, while our employees in other company functions continue to primarily work remotely. These measures have impacted and may further impact our workforce and operations, as well as those of our customers, vendors and suppliers.

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In late 2020 and early 2021, vaccines effective in combating COVID-19 were authorized for use by health agencies in certain countries and regions in which we operate (including the U.S., U.K., European Union, Canada and Mexico) and began to be administered. While the outbreak recently appeared to be trending downward, particularly as vaccination rates increased, new variants of COVID-19 continue to emerge, including the Delta variant and Omicron variant, spreading throughout the U.S. and globally, causing some countries and regions to reinstate travel bans and restrictions. In addition, the availability of COVID-19 vaccines, their continued effectiveness and the need for and availability of boosters are difficult to predict, and vaccination levels vary across jurisdictions. The pace and shape of the COVID-19 recovery as well as the impact and extent of COVID-19 variants or potential resurgences are not presently known. As a result, it is possible the COVID-19 pandemic, particularly in light of variant strains of the virus, could further impact our operations and the operations of our customers, suppliers and vendors as a result of quarantines, facility closures, illnesses, and travel and logistics restrictions.

Supply

The COVID-19 pandemic and related economic effects have disrupted the global supply chain across all modes of transportation, which in turn has resulted in less reliable transportation schedules and increased freight costs. This disruption, combined with increased demand for key raw materials (including those used in COVID-19 vaccine manufacturing), has also impacted our suppliers, resulting in shortages of raw materials or components required to manufacture our products. We continue to work closely with suppliers and freight partners to mitigate impacts to our operations and customers, including the addition of new transportation routes and targeted increases of certain safety stocks. Although we regularly monitor the financial health of companies in our supply chain, prolonged financial hardship on our suppliers and labor shortages could continue to disrupt our ability to obtain key raw materials, adversely affecting our operations. The global industry freight environment has experienced, and could continue to experience, lead time disruptions and increases in shipping costs, negatively impacting our profitability.

Demand

The COVID-19 pandemic has adversely impacted global economic conditions. In particular, the COVID-19 pandemic created significant uncertainty for our channel distribution partners with respect to end customer demand and working capital. Our third party distributors may face difficulties maintaining operations and normal liquidity in light of government-mandated restrictions. Due to liquidity and working capital pressure caused by the COVID-19 pandemic, our distributors continue to manage inventory more tightly. In response to this, along with a shift in tactics for demand generation with our distributors, we reduced channel inventory levels during the first half of 2020 as we tightened our approach across all facets of our distributor relationships. We estimate that this decreased our revenue by approximately $160 million in the first half of 2020. These actions have allowed us to improve working capital management, increase gross margin, implement new compensation structures with our distributors and enable greater control of overall stock levels. For our pet health business, demand in our direct to retailer and e-commerce channels could be negatively impacted by economic conditions as they fluctuate.

In our farm animal business, demand was negatively impacted by processing plant closures in 2020, resulting in a backlog of animals ready for processing, and weakened food service demand, which collectively put pressure on producer economics. Processing plants have adjusted operations and have cleared most of the backlog, and demand for certain protein categories continues to recover. While the impact was most significant for the U.S. livestock industry, particularly in the second and third quarters of 2020, the pressure has occurred globally and across species. As the pandemic continued throughout 2021, our business was affected by lower levels of demand in certain markets due to unfavorable macroeconomic conditions and reduced food service consumption as well as an overall reduction in the bird and animal populations due to herd reduction and disease. As a result, the industry has seen lowered prices and producer profitability across species, most notably in international poultry and aqua. While we anticipate that recovery of end consumer demand will continue to occur, particularly in the food service business, this recovery may be negatively impacted by ongoing labor shortages in the swine, poultry, dairy and beef industries or the effect of inflation on customer profitability. We also expect this recovery to be volatile and uncertain. In addition, demand may be impacted by potential future mitigation measures such as shutdowns if prolonged resurgences in COVID-19 and its variants occur globally.

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We continue to monitor the impacts on our customers' liquidity and therefore our ability to collect on our accounts receivable. While our allowance on these receivables factors in expected credit losses, disruption and declines in the global economy could result in difficulties in our ability to collect, which we have not experienced on a material basis at this time. If significant issues with collections occur, material increases in our allowance for doubtful accounts may be required.

Our Acquisition of Bayer Animal Health and KindredBio

We have incurred and expect to continue to incur expenses in connection with our acquisitions of Bayer Animal Health and KindredBio, including fees for professional services such as legal, accounting, consulting, and other advisory fees and expenses. Expenses incurred in 2021 primarily related to integration activities. In addition, we have incurred and expect to continue to incur costs related to the build out of processes and systems to support finance and global supply and logistics and to expand administrative functions, including, but not limited to, information technology, facilities management, distribution, human resources, and manufacturing, to replace services previously provided by the former parent company of Bayer Animal Health. We anticipate that these additional costs will be partially offset by expected synergies

Product Development and New Product Launches

A key element of our targeted value creation strategy is to drive growth through portfolio development and product innovation. We continue to pursue the development of new chemical and biological molecules through our approach to innovation. Our future growth and success depend on both our pipeline of new products, including new products that we may develop through joint ventures and products that we are able to obtain through license or acquisition, and the expansion of the use of our existing products. We believe we are an industry leader in animal health R&D, with a track record of product innovation, business development and commercialization.

Competition

We face intense competition. Principal methods of competition vary depending on the particular region, species, product category, or individual product. Some of these methods include new product development, including generic alternatives to our products, quality, price, service and promotion. See "Item 1. Business — Competition."

Productivity

Our results during the periods presented have benefited from operational and productivity initiatives implemented following recent acquisitions and in response to changing market demand for antibiotics and other headwinds.

Prior to the acquisition of Bayer Animal Health, our acquisitions within the last six years added in the aggregate $1.4 billion in revenue, 4,600 full-time employees, 12 manufacturing and eight R&D sites. The acquisition of Bayer Animal Health on August 1, 2020 and KindredBio on August 27, 2021 added 3,950 full-time employees, 10 manufacturing sites, and five R&D sites (before company-wide restructuring activities initiated in 2020 and 2021). In addition, from 2015 to 2021, changing market demand for antibiotics and other headwinds, such as competition with generics and innovation, affected some of our highest gross margin products, resulting in a change to our product mix and driving operating margin lower. In response, we implemented a number of initiatives across the manufacturing, R&D and selling, general and administrative (SG&A) functions. Our manufacturing cost savings strategies included improving manufacturing processes and headcount through lean manufacturing (minimizing waste while maintaining productivity), closing three manufacturing sites, consolidating our CMO network, strategically insourcing certain projects, and pursuing cost savings opportunities through alternate sources of supply. Additional cost savings resulted from reducing the number of R&D sites from 16 to eight, SG&A savings from sales force consolidation, and reducing discretionary and other general and administrative (G&A) operating expense.

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Foreign Exchange Rates

Significant portions of our revenue and costs are exposed to changes in foreign exchange rates. Our products are sold in more than 90 countries and, as a result, our revenue is influenced by changes in foreign exchange rates. For the years ended December 31, 2021 and 2020, approximately 51% and 49%, respectively, of our revenue was denominated in foreign currencies. As we operate in multiple foreign currencies, including the Euro, British pound, Swiss franc, Brazilian real, Australian dollar, Japanese yen, Canadian dollar, Chinese yuan, and other currencies, changes in those currencies relative to the U.S. dollar impact our revenue, cost of sales and expenses, and consequently, net income. These fluctuations may also affect the ability to buy and sell our products between markets impacted by significant exchange rate variances. Currency movements increased revenue by 1% during the year ended December 31, 2021. Currency movements decreased revenue by 1% and 2% during the years ended December 31, 2020 and 2019, respectively.

Components of Revenue and Costs and Expenses

Revenue

Our revenue is primarily derived from a diversified portfolio of products across species consisting of dogs and cats (collectively, pet health) and cattle, poultry, swine and aqua (collectively, farm animal). We market our products to veterinarians, pet owners, and farm animal producers, then sell directly or indirectly through third-party distributors, retailers, or e-commerce outlets. For additional information regarding our products, including descriptions of our product categories, see "Item 1. Business — Commercial Operations" and "Item 1. Business — Products."

Costs, Expenses and Other

Cost of sales consists primarily of cost of materials, facilities and other infrastructure used to manufacture our products, shipping and handling, inventory losses and expired products.

Marketing, selling and administrative expenses consist of, among other things, the costs of marketing, promotion and advertising and the costs of administration (business technology, facilities, legal, finance, human resources, business development, external affairs and procurement).

Amortization of intangible assets consists of the amortization expense for intangible assets that have been acquired through business combinations and other business development arrangements.

R&D expenses consist of project costs specific to new product R&D and product lifecycle management, overhead costs associated with R&D operations, regulatory, product registrations and investments that support local market clinical trials for approved indications. We manage overall R&D based on our strategic opportunities and do not disaggregate our R&D expenses incurred by nature or by product as we do not use or maintain such information in managing our business.

Asset impairment, restructuring and other special charges consist primarily of severance costs resulting from actions taken as part of our productivity initiatives and to reduce our costs; long-lived asset impairment charges and write-downs primarily related to product rationalizations, site closures, and the sale of manufacturing sites; transaction and integration costs from acquired businesses and other related expenses, primarily Bayer Animal Health; costs associated with the acquisition of KindredBio; and costs related to the build out of processes and systems to support finance and global supply and logistics, among others, as we stand our organization up as an independent company.

Interest expense, net of capitalized interest consists of interest incurred on our debt.

Other (income) expense, net consists primarily of various items including net (gains)/losses on asset disposals, realized and unrealized foreign exchange translation (gains)/losses, (gains)/losses on equity investments and loss or impairment on other investments.

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Comparability of Historical Results

Our historical results of operations for the periods presented may not be comparable with prior periods or with our results of operations in the future, due to many factors, included but not limited to the factors identified in "Key Trends and Conditions Affecting Our Results of Operations."

Other Recent Acquisitions

Our financial results have been impacted by other recent acquisitions and integrations. For the periods presented, these include primarily the acquisitions and integrations of Aratana Therapeutics, Inc., which closed on July 18, 2019, and Prevtec Microbia Inc., which closed on July 31, 2019. For more information, see Note 5: Acquisitions and Divestitures to the consolidated financial statements.

Results of Operations

The following discussion and analysis of the consolidated statements of operations should be read along with the consolidated financial statements and the notes thereto included elsewhere in this report. For more information, see Note 2: Basis of Presentation to the consolidated financial statements.

Certain amounts and percentages may reflect rounding adjustments.

NM - Not meaningful

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Disaggregated Revenue

On a global basis, our revenue by product category for the years ended December 31 is summarized as follows:

Note: Numbers may not add due to rounding

(1)Represents revenue from arrangements in which we manufacture products on behalf of a third party, including supply agreements associated with divestitures of products related to the acquisition of Bayer Animal Health.

On a global basis, the effect of price, foreign exchange rates and volumes on changes in revenue as compared to the prior year was as follows:

Note: Numbers may not add due to rounding

*Constant exchange rate (CER), a non-GAAP measure, is defined as revenue growth excluding the impact of foreign exchange. The calculation assumes the same foreign currency exchange rates that were in effect for the comparable prior-year period were used in translation of the current period results. We believe this metric provides a useful comparison to previous periods.

Revenue

Pet Health revenue increased by $993 million or 73%, partially driven by Bayer Animal Health product revenue of $1,194 million as compared to $339 million in the prior year. Legacy Elanco revenue increased as a result of a favorable comparison to the prior year, during which we reduced channel inventory levels with our distributors in the first half of 2020 and experienced reduced demand for veterinary products, primarily in U.S. vaccines and international markets, due to the COVID-19 pandemic. Growth in the legacy Elanco business primarily related to increases in volume and price and, to a lesser extent, the positive impact of foreign exchange rates. U.S. parasiticides and therapeutics led price growth, and higher volumes were attributable to newer generation parasiticides, pain products, and new products launched in 2021. These factors were partially offset by declines in older generation parasiticides and the impact of divestitures.

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Farm Animal revenue increased by $497 million or 27%, mainly driven by Bayer Animal Health product revenue of $643 million as compared to $226 million in the prior year. Legacy Elanco revenue increased as a result of a favorable comparison to the prior year, which included lower levels of demand due to the COVID-19 pandemic's impact on global protein markets, as well as actions taken across brands to reduce channel inventory levels in the first half of 2020 due to the pandemic. Growth in the legacy Elanco business primarily related to increases in volume and a positive impact from foreign exchange rates. Revenue increases from volume growth in global cattle and U.S. swine, improvement in international poultry and aqua, and new products launched in 2021 were partially offset by generic competition, lower levels of demand in China's swine market due to pressured producer profitability, the impact from exiting certain operations in 2021, and an unfavorable comparison for U.S. cattle vaccines and implants, which benefited from a short-term competitor stock-out in the fourth quarter of 2020.

Contract Manufacturing revenue increased by $2 million to $82 million and represented 2% of total revenue. Contract Manufacturing revenue for the period includes $66 million resulting from the acquisition of Bayer Animal Health.

Cost of Sales

Cost of sales increased $467 million in 2021 as compared to 2020 primarily due to increased sales, partially offset by lower amortization of the inventory fair value adjustment associated with the Bayer Animal Health acquisition. Cost of sales as a percent of revenues decreased to 45% from 51%. This decrease was due to the inclusion of Bayer Animal Health products, which have higher margins, as well as continued improvements in manufacturing productivity, increases in price, and lower amortization of the inventory fair value adjustment.

Excluding the amortization of the inventory fair value adjustment associated with the Bayer Animal Health acquisition, cost of sales as a percent of revenue would have been 43% and 48% in 2021 and 2020, respectively.

Research and Development

R&D expenses increased $42 million to $369 million in 2021 as compared to 2020, primarily due to the inclusion of the Bayer Animal Health and KindredBio businesses. As a percent of revenue, research and development was 8% compared to 10% in the prior year. The decrease was primarily due to the rationalization of R&D projects, personnel and site operations in the current year following the acquisition of Bayer Animal Health as well as a higher revenue base.

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Marketing, Selling and Administrative

Marketing, selling and administrative expenses increased $408 million in 2021 compared to 2020, primarily as a result of the acquisition of Bayer Animal Health, increased promotional spend for direct-to-consumer and digital advertising, increased information technology spending, increased legal and administrative costs, and increased legacy Elanco compensation and benefits due to the addition of employees to perform activities that were previously covered by the TSAs with Lilly that were exited during the first half of 2021. These increases were partially offset by disciplined cost management across the business and realization of synergies.

Amortization of Intangible Assets

Amortization of intangible assets increased $196 million to $556 million in 2021 as compared to 2020, primarily due to the inclusion of a full year of amortization of intangible assets recorded from the acquisition of Bayer Animal Health.

Asset Impairment, Restructuring and Other Special Charges

For additional information regarding our asset impairment, restructuring and other special charges, see Note 6: Asset Impairment, Restructuring and Other Special Charges to the consolidated financial statements.

Asset impairment, restructuring and other special charges increased $5 million to $628 million in 2021 as compared to 2020, primarily due to a $273 million charge to write down assets at our Shawnee and Speke sites that were classified as held for sale to an amount equal to estimated fair value less costs to sell, a $26 million charge to establish a liability for future royalty and milestone payments relating to our canine parvovirus license agreement with KindredBio, and $66 million of impairment charges for intangible assets that were subject to product rationalization in the current year. The impact of these items was partially offset by a year over year decrease in overall acquisition related charges, which include transaction costs related to acquisitions, costs associated with the implementation of new systems, programs, and processes due to our separation from Lilly, and costs associated with the implementation of new systems, programs, and processes in connection with the integration of Bayer Animal Health. The increase as compared to prior year was also partially offset by a decrease in severance charges as compared to 2020, $29 million of pension curtailment gains and a $16 million reversal of severance accruals during the period due primarily to favorable negotiations.

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Interest Expense, Net of Capitalized Interest

Interest expense increased $86 million to $236 million in 2021, primarily due to interest associated with the Term Loan B entered into August 1, 2020 and used to finance the Bayer Animal Health acquisition and additional debt used to finance the KindredBio acquisition.

Other (Income) Expense, Net

Other expense recorded during 2021 primarily consisted of mark-to-market adjustments on equity investments and foreign exchange losses, partially offset by gains on divestitures, certain components of net periodic benefit income, an up-front payment received in relation to an asset assignment agreement, a milestone earned in relation to an existing asset sale agreement, and up-front payments received, milestones earned, and equity issued to us in relation to a license agreement. Other income recorded during 2020 was primarily composed of gains recorded on the divestitures of certain products and a $46 million gain on the sale of land and buildings in New South Wales, Australia.

Income Tax Expense (Benefit)

Our historical income tax expense may not be indicative of our future expected tax rate. See “Comparability of Historical Results” for further discussion.

Income tax benefit decreased $17 million to $95 million in 2021, primarily due to a pre-tax loss partially offset by a non-cash charge of $62 million relating to the increase of the valuation allowance on U.S deferred tax assets. See Note 15: Income Taxes to our consolidated financial statements.

Liquidity and Capital Resources

Our primary sources of liquidity are cash on hand, cash flows from operations and funds available under our credit facilities. As a significant portion of our business is conducted internationally, we hold a significant portion of cash outside of the U.S. We monitor and adjust the amount of foreign cash based on projected cash flow requirements. Our ability to use foreign cash to fund cash flow requirements in the U.S. may be impacted by local regulations and, to a lesser extent, following U.S. tax reforms, the income taxes associated with transferring cash to the U.S. We currently intend to indefinitely reinvest foreign earnings for continued use in our foreign operations. See Note 15: Income Taxes to the consolidated financial statements for further discussion. As our structure evolves as a standalone company, we may change that strategy, particularly to the extent we identify tax efficient reinvestment alternatives for our foreign earnings or change our cash management strategy.

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We believe our primary sources of liquidity are sufficient to fund our short-term and long-term existing and planned capital requirements, which include working capital obligations, funding existing marketed and pipeline products, capital expenditures, business development in our targeted areas, short-term and long-term debt obligations which include principal and interest payments as well as interest rate swaps, operating lease payments, purchase obligations, and costs associated with the integrations of Bayer Animal Health and KindredBio. In addition, we have the ability to access capital markets to obtain debt refinancing for longer-term funding, if required, to service our long-term debt obligations. Further, we believe we have sufficient cash flow and liquidity to remain in compliance with our debt covenants.

Our ability to meet future funding requirements may be impacted by macroeconomic, business and financial volatility. As markets change, we will continue to monitor our liquidity position. However, a challenging economic environment or an economic downturn may impact our liquidity or ability to obtain future financing. See "Item 1A. Risk Factors - We may not be able to generate sufficient cash to service all of our indebtedness and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful."

Cash Flows

The following table provides a summary of cash flows from operating, investing and financing activities for the periods presented: